MCD – McCafe – Collecting trench data

“Looks like desperation to me! Telling us they've got it all figured out and are ready for national prime-time and then start tinkering with the basic product???”

“What the WSJ did not report is that the testing in Detroit is a result of the proven fact that the African American consumer has little interest in the fancy coffee drinks. Remember, all of Michigan has had these products for over two years so they've proven the weakness in the urban setting.”

“Even though sales aren't strong the outstate MI, stores sell two specialty coffee drinks for everyone one sold in Detroit metro. So this means that the sales of specialty coffee index at about 75% for AACM to the General Consumer Market during promotional periods. During sustaining periods without heavy promotion sales in the AACM is about 50% of the GCM. Hence the change in formulas (adding chocolate) being tested in Detroit”!


I’ve got a simple thesis on the slot business. Senior corporate management will control the slot Capex decisions in 2009 for the casino operators. I’m not sure the analysts are considering this important observation in their estimates nor are the suppliers in their guidance.

Casino operators are preparing their Capex budgets right now. I know they’re scared. Gaming revenues are down considerably and September was one of the worst months ever. Most importantly, senior managements are very worried about liquidity and covenants, particularly in the first half of 2009. Slot Capex comprises the largest part of maintenance Capex and is the easiest to delay.

I think the suppliers are overestimating 2009 slot demand. Part of this miscalculation is the classic forecasting error of assuming that current trends will continue. Additionally, the suppliers are getting indications of slot demand from casino level management. Unfortunately, 2009 slot decisions will be made at the corporate level and not at the casino level. Another price of excessive leverage.

The chart below examines current Street estimates for slot unit demand and revenue for the first half of 2009. For the Big Three, Analysts are projecting market growth in both metrics over this time period. In the case of BYI and WMS, the estimates are even less believable. I understand that both companies have stolen market share from IGT and may continue to do so. If you believe, as I do, that unit demand and revenues will decline in the first half of next year, further market share shifts would have to be dramatic for WMS and BYI to hit those numbers.

Analysts projecting growth in first half of 2009


A century ago the decaying Ottoman Empire was known as “the sick man of Europe”. This creaky and corrupt body finally imploded under the disastrous foreign policies of the “Young Turks” (who seized power in 1908) which reached a nadir in the defeat of WW1 and subsequent partition.

During the 1920s Mustafa Kemal, an officer who emerged from the war as the hero of Gallipoli, gained power and rebuilt his nation over the following decades -creating a modern secular democratic state. Today Kemal (known as “Ataturk”) is still revered to the extent that it is a crime to publicly disparage him and his policies. Each year on November 10 –the anniversary of his death, the entire nation observes a minute of silence. Kemal was a transformational leader who guided his country through a volatile period of history; it’s likely that this November 10th Turkish thoughts will be focused on how their nation can best navigate the current world crisis.

Over the past decade Turkey has gone through a manic series of highs and lows. A devastating earthquake in 1999 and humiliating IMF bailout after the collapse of 2001 were followed by reform and years of rapid economic growth which saw the former “sick man” rise to be the 6th largest economy in Europe. The prospect of EU membership in 2005 –at first a source of euphoria, has since become a sore subject as issues like Cyprus and the Armenian genocide controversy have slowed the ascension process to a crawl. Meanwhile, tensions with NATO partners over Kurdish separatists on the Iraqi border and internal debate between Islamic beliefs and Turkish secular values have been ongoing sources of friction.
This year the Turkish markets have been battered by the global storm. Since the beginning of the year the ISE 100 stock index has lost half of its value –surrendering over 20 % in October alone. The Lira has been hurt in 08 as well, declining 20% against the dollar so far.

The data supporting the negative consensus case for Turkey is simple:
· The country has never fully recovered from the 2001 crisis. The current account deficit stood at 5.8% at year end 2007, statistically high by the standards of major emerging economies and its credit rating remains speculative, leaving it prone to external credit shocks;

· Turkey has seen its fortunes rise with the EU (responsible for over 50% of Turkey’s foreign trade) and, now that the economies of their trading partners to the north are slowing (if not stalling completely), Turkey will suffer disproportionately in the coming recession as a weaker peripheral player. Meanwhile its other major trading partners, the US, Russia and Japan are facing prospects equal or worse than the EU; and

· The security issues that come with sharing borders with Iran, Iraq and Georgia are nightmarish.
We are beginning to explore a contrarian thesis, based on less negative data points:

· Turkey has successfully reduced external debt as % of GDP to just over 37% since the 2001 crisis -although with a speculative credit rating it will not necessarily have access to credit markets anytime soon, this lessened debt load may help insulate it from the prospect of downgrades. Additionally, the main trade deficit driver has been oil and other commodities, which are now in freefall;

· So far the Turkish banking system has proved relatively resilient (there is some speculation that the regulatory environment there made it made it more difficult for Turkish banks to hold derivative instruments on their balance sheets during the credit market boom years than it was for their foreign counterparts, thus protecting them);

· According to the OECD’s July report: “Turkey continues to have some of the most rigid labor and product market regulations of the entire OECD area. Doing business in compliance with the law remains less attractive than in most other OECD countries”. With abundant inexpensive skilled labor and a geographical position that provides access to not only the EU markets but also the Gulf States via Iraq and Central Asia via the Caspian states, Turkey could help attract more foreign investment if its government took steps to lower these barriers to entry- an idea that appears to be gaining support among political leaders; and

· Although unemployment continues to be a real issue (a factor that could well be compounded by slowing opportunities for work abroad in EU nations) consumer inflation has been held in check for the past 4 years, hovering around 10%, and internal consumer demand has been relatively resilient in recent months.

In the coming weeks we will continue to keep our eye on Turkey as we weigh its prospects on a relative basis against its EU and Middle East neighbors. If, after consideration, we decide that the glass is half full we will report back.

Andrew Barber

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Leases: Ghost Leverage Exposed

Lease structures matter more than ever when the rest of the margin equation gets stressed. This is when the aggressive models are exposed, and the conservative models are rewarded.

Those who have been tracking my analysis know that I’m pretty much obsessed with operating lease structures for retailers. Not out of morbid curiosity, but by the way that striking such agreements as it relates to duration, and varying step-up factors can meaningfully distort current earnings streams. Here are two Exhibits showing two overriding themes. 1) Minimum lease obligations over 5 years versus current operating margins, and 2) The incremental change in that rate over the past 2 years. Some interesting conclusions…

1) Those with the healthiest lease obligation ratio include Timberland, Warnaco, Philips-Van Heusen, Columbia, Payless, Hibbett, Carter’s Nike and VF Corp. These are companies that have a call option to alter lease terms (i.e. lower near-term payments, but higher escalators, or for example), and improve operating margins. Whether or not this strategy is wise, it is an option.

2) The companies with the poorest positioning are Dick’s, DSW, Skechers, and BJ’s. I’d even highlight Coach and Abercrombie as high margin, low flexibility portfolios. That’s not to say that there is massive risk to those models, but simply that if business slows meaningfully, their respective options are more limited to tweak the portfolio to ease a margin pinch.

1) In looking at the incremental change in ‘flexibility ratio’ over the past 2 years, there are some clear standouts. Timberland, Finish Line, Columbia, Ralph Lauren, Van Heusen, Warnaco, and Hibbett all look particularly good, with improvements of 10 points or more.

2) On the flip side, Skechers, Quiksilver, Carter’s, VF Corp, Nike, and to a lesser extent Abercrombie all register at the opposite end of the spectrum. These companies have been taking up forward minimum obligations relative to current payments. This is not always bad, as it might be explained away by a change in business mix (i.e. JNY’s got worse bc it divested Barney’s). But overall, it is a way for a company to boost current margin run-rate, and is a key factor to watch.

Positive Standouts: Timberland, Columbia, Ralph Lauren, Phillips-Van Heusen, and Hibbett.

Negative Standouts: Skechers, Dick’s, DSW, Carter’s VF Corp and Nike.

Click on charts below for a larger view, or email me for the Excel file.

Eye on Behavioral Finance: Confidence

“I always knew I was going to be rich. I don’t think I ever doubted it for a minute.” -Warren Buffet

Investors have a love / hate relationship with confidence. On one hand, being confident in your analysis, process, and team is critical to making sound and successful decisions. On the other hand, overconfidence, especially to the point of hubris will lead to risk taking, which can ultimately lead to losses that become insurmountable.

The word hubris finds its root in the Greek work hybris. In ancient Greece, hybris referred to actions of those who challenged the gods or their laws, which led to their eventual downfall. In fact, hybris was considered the greatest sin of the ancient Greek world. The story of Icarus is one of the most telling examples of hybris in ancient Greek mythology. Despite repeated warnings from his father Deadalus, Icarus was overcome with the giddiness of being able to fly and flew to close to the sun. He burnt his feathers, was no longer able to fly, and fell into the sea.

In investing it is critical to be aware of overconfidence and protect against the development of hubris, particularly after a recent period of success in the markets. This success can lead to, naturally, a feeling of overconfidence and more rampant risk taking. This psychology predicament is well known in many fields. In the military, this is referred to as “victory disease” as successful military commanders have a tendency to demonstrate poor judgment after a series of military victories. Napolean’s ill fated invasion of Russia is, perhaps, one of the more notable examples.

From an investment perspective, overconfidence creates at least three fatal flaws: miscalibration, better than average effect, and illusion of control.

- Miscalibration occurs when investors overestimate the precision of their knowledge and tend to use confidence intervals that are too narrow. In a paper by Graham and Harvey, CFOs were given a multi-year survey and asked to give their 80 percent confidence interval for stock market close over the next year. When over 4,300 forecasts were measured against the actually results, only 30.5 percent, or less than a third, were accurate within the 80 percent confidence interval.

- Better than average effect occurs when people grossly misjudge their abilities. This was highlighted in a recent Washington Post poll in which, “94 percent of Americans said they were above average in honesty, 89% in common sense, 86 percent in intelligence, and 79 percent in looks.”

- Illusion of control involves the belief that one may be able to influence random events. In a famous study by Langer and Roth, participants were asked to flip a coin ten times with rigged results. When asked how they would do in a game of 100 flips, those who started with a series of wins expected to do much better and, additionally, almost forty percent believed they would get better with practice.

Overconfidence is much more than just a behavioral economic trait that we need to be aware of it, it also has an actually physiological foundation in the way of dopamine, which is a chemical that the body generates to reward “success” and by creating a feeling of pleasure. Keith has previously posted on the impact of dopamine and Richard Peterson summarizes this effect well in his book “Inside the Investor’s Brain”:

“The dopamine-based reward learning process encodes a profitable pattern of behavior. Subsequently, however, highly profitable traders may have difficulty maintaining the same level of attention to risk management because of a chemical shift in their brains. They become slightly bored and push the limits of their abilities and risk exposures in order to continue to feel challenged. The combination of low relative dopamine levels during during trading (because they have already learned profitable techniques) and elevated norepinephrine levels provokes increased boredom, distractibility, and scanning for new opportunities.”

Too much success, in effect, can change an investor’s brain and lead to chemically based overconfidence that will lead to excessive risk taking.

To be clear, as we attempted to highlight in the quote from Buffet at the start of this note, confidence in your abilities is also critical in the achievement of investment success, and success in life broadly. If you do not believe in your process and your team, then your ability to make timely decisions will be limited, but this confidence must be framed in rationality. In effect, you can only achieve what you believe you can achieve. As Jack Schwager wrote in Market Wizards:

“One of the most strikingly evident traits of all the market wizards is their high level of confidence . . . But the more interviews I do with market wizard types, the more convinced I become that confidence is an inherent trait shared by these traders, as much as contributing factor to their success as a consequence of it . . . An honest self appraisal in respect to confidence may be one of the best predicators of trader’s prospects for success in the markets.”

A starting place of any success, whether in investing or otherwise, is in confidence, but at the same time we must be very wary of the pitfalls of overconfidence. A method we use at Research Edge is to keep investment journals. While this seems trivial, it is also a way to quickly and accurately verify when your success is based on skill versus luck. It also provides us the ability to look back and learn from our mistakes.

Daryl G. Jones
Managing Director

Quote Of The Week: John Mack, CEO, Morgan Stanley

"MUFG’s investment is a powerful endorsement of the tremendous value in the Morgan Stanley franchise, but the caliber and commitment of our people give me even greater confidence about the future of this Firm,”...
-John Mack, 2008

This, of course, is Morgan Stanley’s version of a white knight, MUFG (as in Mitsubishi Financial)... as in the Japanese firm that cut their outlook by another 50% versus expectations this week and announced that they need to find another 990B in Yen of liquidity...

The aforementioned quote by Mack, was not one he made this week. He said it earlier in the month, when guiding the Street to whatever light he saw in levering MS to another over-geared bank. There have been multiple points in this economic downturn's history that the said leaders of "Investment Banking Inc." and the US Treasury (are they one and the same?), have issued global investors short sighted perceptions versus reality. Our promise is to ‘You Tube’ them.

If the excuse is that “no one could have proactively seen this financial tsunami coming”, we’re short that. If there is no proactive risk management or research process, we’ll just call it out for what it is – being wrong.

We hear, quite often, that Mack is a good guy. This quote is unfortunate.

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