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Everyday hundreds of millions of people around the world wake up and drink a cup or two of coffee in the morning. It’s a habit for some and will remain that way forever. Starbucks is a brand that has relevance in our society and can satisfy the habits of millions. How many times have someone said to you let’s meet at Starbucks and get a cup of coffee? It happened to me yesterday! At Research Edge we think the timing is great to start a consumer fund with a 3-5 year investment horizon. There are some incredible opportunities given the debacle in consumer names. Starbucks would be one of the names we would put in that portfolio. Don’t misunderstand my positive tone has nothing to do the quality of the quarter to be reported on November 10th. A lot has changed since the last time the company gave guidance to the street.
  • Starbucks still faces significant headwinds as it adjusts to the global consumer macro issues. Since the company last gave guidance for 2009, consumer sentiment is falling and spending has slowed. The company current expectations are for same-store sales to grow 2-3% for fiscal 2009, with no pricing. This appears to be aggressive given the current trends in consumer spending. Every company is facing theses issues and Starbucks is better positioned than most to deal with them. To the degree that smaller competitors can’t survive, Starbucks’ opportunities grow.
  • In the short run, two big negative commodity factors have swung positive for the company. Over the past couple of weeks, we have posted extensively on the decline in both milk and coffee prices. While they will not provide any significant benefit to the company in its fiscal fourth quarter reported on November 10, lower commodity prices will have a positive impact in the first quarter of fiscal 2009 (higher dairy costs resulted in a negative $0.02 impact to EPS in fiscal 1Q08).
  • Another short term issue includes consumer demand at the company’s core U.S. store base. Last week, CEO Howard Schultz made the following comments to reporters at a company leadership conference in New Orleans; "The downturn continued in the fourth quarter, and we did see a slight improvement in the first weeks of Q1 ... which might suggest that Starbucks may have hit bottom in terms of negative transactions in our fourth quarter.” If I had 3-5 year investment horizon, SBUX would be on the top 10 list of consumer stocks to buy….. But, why did Howard need to be this vocal about business trends? I don’t see any upside at this point...
  • I believe Howard is also seeing the benefits of the company’s efforts to slow store growth and close underperforming stores. The shrinking of the U.S. asset base (closing stores and rationalizing the U.S. infrastructure) will eliminate cannibalization and close underperforming stores, which will help to improve same-store sales trends.
  • For most consumer companies there is not much that can be done to offset the macro environment. Therefore given today's turbulent investment environment, cash and the redeployment of cash flows will be a critical factor in determining future levels of valuation and, therefore, stock price performance. A cash flow sustainability analysis suggests that managing cash flow properly will allow any given company to outperform its peer group over a sustainable period of time. A key component to sustainable, consistent growth and a premium valuation is the proper balance between cash reinvested into the business and cash returned to shareholders. We all know that Starbucks had tipped the scales too far in favor of growth. What is not clear is how the capital allocation decisions made in fiscal 2008 will impact 2009. Our model suggests one outcome, but the reality of the reported numbers will not be evident for 3-6 months. Over the next two years SBUX will likely generate about $1.2 billion in free cash flow, but this number could move higher because I think FY09 capital spending still has the potential to come down further. To date, management has not spoken about what they intend to do with this cash. In all likelihood the company will pay a dividend for the first time in the company’s history. The divided could be anything from $0.15 to $0.25 per share. At the high end it would provide shareholders 2% yield, helping to put a floor on the stock.
  • Lastly, the investment community is so sure that MCD will put SBUX out of business, or at least significantly erode the profitability of SBUX’s business model. I’m confident that the MCD coffee program is not working – there is clear evidence that MCD is way behind on its store conversion schedule and they are still tinkering with the recipe. SBUX is the cheapest global restaurant company I follow (6.5x NTM EV/EBITDA) with great cash flows and global opportunities, but patience pays.

Point Counterpoint: GES, LIZ, RL, SKX, COLM, CROX

Here’s the latest intersection between Keith’s factor models, and my fundamental models. Combining the two has improved our team’s batting average. Lots of opportunity out there…

KEITH: GES lined up to be knocked down again. From here to 25.96 it’s a short. Any catalysts?
BRIAN: Yes. When the company comes out with earnings in another month, it will take down numbers.

KEITH: LIZ has a lot of work to do, but if it can hold 7.32, it has a prayer.
BRIAN: A lot of work to do indeed. But we’re going to start to see more of that work payoff over the next 2 quarters. The P&L is a mess, but people are looking through capex and sg&a cuts. Cash trajectory looks good to me.

KEITH: SKX failed right where it should have (13.48); it will see $11, soon, if the fundamental river card shows.
BRIAN: Let me be clear on this one… I think margins are going close to zero. But I’m not sure we’ll see Keith’s fundamental river card before year end.

BRIAN: My gut (and my math) gets me to a beat on the quarter, and if there is a guide down, it should not be by much. For a global power brand like RL that is coming off a period of investing in both its P&L and balance sheet while many competitors have been doing the opposite, I like its competitive positioning at 6x EBITDA.
KEITH: Stock was a buy at 38 on the prospect of a beat on the Q… not at 48.
Editor’s (Brian’s) Note: The key factor here in our differing view is duration mismatch.

KEITH: COLM holding 35.76 looks like a long.
BRIAN: I agree on the fundamentals here. Not rosy by any means, especially with Spring backlog so weak. But COLM is 3-quarters into a period of SG&A investment that I have been waiting for five years to see. The company is finally investing in its content. Don’t underestimate how that could reverse the trajectory of a flailing top line.

KEITH: CROX has 29% of the shares held short, and is now a long provided it can hold 2.48. Up another 26% Tuesday. Someone knows something …
BRIAN: If someone knows something imminent, it’s not me. Imminently, earnings/cash flow is a black hole. CROX should have reported yesterday, but they have not even announced their reporting date. Fundamentally, I like the idea of a take-out. Enterprise value of $232mm, and regardless of the ‘fad-factor’ of its core product, I think Crocs is a brand, not a product. Someone larger will own this company within a year. My bet rests with Skechers, which can buy CROX with its cash on hand. The duration of a call on this one is the biggest question in my mind.

Confucius Says...

“And remember, no matter where you go, there you are…”

This is one of the simplest, yet most relevant quotes in my investment notebooks. In a word, I call it accountability. Hide from it at your own risk. There’s a new sheriff in this town of global market leadership – her name is ‘You Tube’… and she will hunt you down.

The transparent drama of political life in this country will finally find an apex tonight. Obama will likely be accepting a rock-star victory at a reception in Grant Park in Chicago, Illinois, while the “Straight Talk Express” will be chalking up another Presidential race loss… this time, at the Biltmore in Phoenix, Arizona.

The paths of these two men provide a metaphor for where the United States has been vs. where it’s going. Grant Park is 319 acres of open air which hosts America’s mosh pits at Lollapalooza, whereas the Biltmore is one of our citizenry’s sites of haute couture, Cartier watches, and Cindy marrying the “Maverick” back in 1980. “No matter where you go… there you are.”

Much to the chagrin of the bears who are running around pitching my 9 month old “Macro” thesis’, we’ve been all “bulled up” as of late. We’ve been using Obama’s pending election, credit spreads narrowing, and earning’s season ending, as a trifecta of catalysts for a new beginning. No matter how good or bad a year you are having in this market, you have to have your feet on the floor this morning, proactively managing towards tomorrow. People don’t care about your October anymore. They want to know where you are today, and where you are going next. “No matter where you go… there you are.”

So where to next, “Mr. Mucker”? While it’s nice to be called “Mr.” these days, I do still enjoy the odd crackberry addict firing off at me, calling me names. It inspires me to work harder. So let’s strap on the analyst pants and get back to the notebooks. First, for context, let’s go through the math. Since our “Buy’em” Early Look note from 10/27 (www.researchedgellc.com), the S&P500 has rallied from 848 to 966 (up +14%), Volatility (VIX) has plummeted from 80 to 53.68 (down -33%), International stock markets have been squeezed for anywhere from +15-30% moves, the US Dollar has lost -3% from its peak, and international currencies have stopped going down. “No matter where you go… there you are.”

Context is always critical when attempting to proactively predict markets and/or the tail risks implied therein. Respect history, or it will teach you lessons the hard way. With the aforementioned bullish macro backdrop, you have to face the facts this morning and look towards a less dark future. Obama’s win is the obvious catalyst that global stock markets have started to discount, but the less obvious ones are A) that the yield curve continues to steepen and B) inflation readings continue to dampen. This combination is a powerful one. It gives countries from Asia to Europe the objective facts needed to join hands and cut rates. The Reserve Bank of Australia cut rates this morning by another 75 basis points to 5.25%, and on Thursday, both the ECB and the Bank of England will be cutting them again as well. Don’t be short that calendar.

In yesterday’s Federal Reserve Senior Loan Officer Survey, the simpleton’s conclusion should have been more of what we have been calling for the past 9 months – access to credit continues to tighten as cost of capital continues to rise. No, “Heli-Ben” dropping money from the heavens hasn’t done a darn thing for 30 year mortgage rates other than inflate them. No, Paulson’s Biltmore Club collaboration for “Investment Banking Inc.” hasn’t helped one corporate borrower who needs long term debt financing – 10 year Treasury yields are testing 4% this morning - they are breaking out!

No, this won’t make sense to all of the “hedgie” freedom fighters who said they “don’t do Macro”… nor will it help my 60% position that I still have parked in US cash. Cutting rates to zero doesn’t inspire one to save anything. Cutting rates to zero ultimately means you can only RAISE them next! That’s why long rates are headed higher as short one’s nosedive. This, all together, is outstanding news for what we have labeled as a Research Edge Investment Theme for 2009 – “The New Reality.”

“The New Reality” is that yesterday’s Wall Street is going away. They can house it alongside the horse and the buggy whip at the Biltmore museum. Bush’s administration will be gone. Paulson’s team will be too. This is great for those looking for new beginnings. This is great for Americans who are liquid long cash. Borrow short, lend long. Charge those in need of leverage a healthy premium. Rinse and repeat. “And remember, no matter where you go, there you are.”

Our immediate term target for the S&P500 is now 990. A close above that level gets my allocation to US cash under 50%. A failure, and close below that level re-sharpens my bear claws.

Have a great day,

Long ETFs

JO – iPath Coffee – Arabica futures declined on ICE on further anticipated index investment outflows. Vietnam Coffee and Cacao Association warned producers face major bottleneck unless banks open credit lines to wholesalers.

EWG – iShares Germany – Eurozone PPI was reported for September at +7.9Y/Y, lower than expected on declining oil costs. BMW traded up 8% after guiding for ``clearly positive'' earnings after production cutbacks.

FXI – iShares China – CSI 300 index declined over 1.5% as basic material and energy companies guided lower on falling global commodity prices. China’s top tin producers announced significant capacity cuts as demand slackens.

VYM – Vanguard High Dividend Yield ETF – Depository Trust & Clearing Corp. will publish details of the top 1,000 credit default swaps today after 5PM, under regulatory pressure. Information will include gross and net contracts outstanding as well as trading volume.

Short ETFs

UUP – U.S. Dollar Index – The Euro rose against the dollar today on declining money market borrowing cost, anticipated rate cut from the ECB in 2 days further increasing liquidity.

EWU – iShares United Kingdom – Apparel retailer Marks & Spencer up over 10% after reporting smaller than expected loss, continued dividend. RBS declined 9% on write-down’s, declined to forecast full year results.

IFN – The India Fund – SENSEX and the Rupee rose for fifth consecutive day. Finance Ministry reports that the Reserve Bank may open 100 billion INR credit lines to the National Housing Bank and Small Industries Development Bank to increase flows for mortgages and small companies.

Keith R. McCullough
CEO & Chief Investment Officer

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Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.


We looked at the relationship between gaming operator and supplier stocks over the past 10 years. As one would expect, the relationship was strong. Interestingly, the strongest relationship was gaming operator stocks driving supplier stocks on a six month lag.

Intuitively, this makes sense. When business is bad, cash flows decline, liquidity is a more pressing need, and suppliers cut back on slot capex. Operators do not immediately cut back on slot capex when their business turns down, nor do they immediately communicate to the suppliers that they are cutting back. Hence, the lag.

This relationship could be tested in the coming quarters. As discussed in my post “CAPEX, COVENANTS, AND CORPORATE CONTROL”, I expect corporate managements of the operators to direct slot capex lower in the first half of 2009 due to liquidity issues. Even if gaming trends improve sequentially, I anticipate slot purchases to be pushed back into the second half of the year.

Most significantl statistical relationship is a 6 month lag

RL: This Quarter is All in the Details

There’s never been a quarter with RL where looking at the puts and takes vs. the year-ago period mattered more. Here’s a detailed margin walk to guide the way. Yes, revenue stinks. I can’t imagine anyone on Wall Street thinks otherwise. Tack on the fact that a consistent 6-8% boost in sales from acquisitions and another 2-3% from FX goes away, and the top line ain’t very pretty. But I think there’s enough juice on the cost side to serve up a pretty decent headline number. After adding up the Impact 21 and Small Leather Goods dilution from last year, FX-driven SG&A, and a meaningful step-up in both cash and stock-based comp, RL has about a 150-175bp pad built into margins for the next two quarters. My gut (and my math) gets me to a beat on the quarter, and if there is a guide down, it should not be by much. When I stress test t he model (email me for a copy) I get to a bear case number for this year above $4.00 per share. I’ll almost never pay up for a cost leverage story. But for a global power brand like RL that is coming off a period of investing in both its P&L and balance sheet while many competitors have been doing the opposite, I like its competitive positioning at 6x EBITDA.

Click on images below to enlarge.


I think estimates for the first half of 2009 are probably too high for all of the gaming equipment suppliers, although IGT could save its way there. Revenue estimates look too aggressive as discussed in my post “CAPEX, COVENANTS, AND CORPORATE CONTROL”.
  • IGT could probably get away with a revenue miss since sentiment is already so low. The company guided down last week, but the general feeling is that there could be more downside. The fact that 12 analysts maintain hold or sell ratings on the stock versus only 5 with buys, is not helping sentiment either. The first chart details the ratings breakdown by company.

    WMS, on the other hand, is loved by the sell side. Of the 16 analysts that cover the stock, 14 have buy ratings. I've got to believe the optimism is reflected in the earnings estimates as well. Indeed, analysts are projecting 10% revenue growth in the face of likely Capex resets in 1H 2009 by the operators. I’ve already stated my opinion on that subject.

  • It looks like the analysts have been persuasive with the buy side. As shown in the second chart, WMS trades at a 35-45% premium to IGT and a whopping 65-75% premium to BYI. Despite the potential for a 1H revenue shortfall, BYI looks cheap at under 10x earnings.

    While I worry about the whole group, revenue shortfalls on cheap stocks are likely to be less damaging than for a more expensive one with higher ratings.

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