KSWS: Opening Up Our Internal Debate

Very differing view on KSWS at our morning meeting today. Here are the pros and cons by the broader team…
We just got out of our morning meeting, and had a particularly spirited debate about K Swiss, and Casey Flavin’s posting from earlier. Casey and I took the special dividend as good for shareholders today, but limits the opportunity set to build create value with existing assets and acquire new ones on the cheap (there are many) with its pristine balance sheet. Also, business is not good, the company is entering new product lines with varying working capital requirements, and the time just seems too early for me to comfortably stomach.

On the flip side, our Macro team – Keith McCullough and Daryl Jones took the polar opposite side that this was one of the most capitalist-focused moves this market has seen of late. Dole out a quarter of your cash, and still leave the company with a solid balance sheet and a lot of dry powder to keep optionality high. If the CEO can pay himself and his team along the way, then all the better.

Feel free to email me your 2 cents. I’d love to hear your view. Right or wrong, I never come out of a debate less smart and informed than when I went in.

Casey Flavin

YUM – U.S. Cost Cutting A Must

The Associated Press reported yesterday that YUM will be eliminating several hundred jobs and shifting up to a couple hundred more as a part of its U.S. restructuring plans. Company spokesman Jonathan Blum provided details, saying that several hundred jobs will be eliminated at YUM’s Louisville operations as well as at Taco Bell's headquarters in Irvine, CA, at Pizza Hut's headquarters in Dallas and in field operations nationwide. In addition, an unspecified number of cuts will be achieved by not filling open positions. Also, up to a couple hundred more positions will be shifted from YUM's corporate headquarters in Louisville to the company's brands. "We believe this will enable us to operate more effectively and improve our cost structure," Blum said.

YUM’s U.S. business has been significantly underperforming the company’s China and International segments and in each of the last two quarters posted operating margins that were down in the 200 basis point range YOY. YUM’s U.S. blended same-store sales growth finally turned positive in 2008 after six quarters of declines, but operating margins have not yet reflected this improvement. Management has attributed this profit underperformance to significantly higher commodity costs and continued weakness at its KFC brand, which posted a 4% decline in comparable sales in the most recent quarter. The company continues to maintain that it will be able to turnaround KFC in 2009 and generate profit growth, but this relies largely on the success of its 2Q national launch of Kentucky Grilled Chicken.

Additionally, management outlined on its 3Q08 earnings call an aggressive U.S. cost reduction initiative to help yield improved profitability in 2009. At the same time, YUM is proceeding with its refranchising plans and is still targeting U.S. company ownership of below 10% by the end of 2010, which would also improve U.S. margins. Management has commented, however, that although still on plan, current credit conditions have slowed down the timing of these refranchising transactions. The company expects its cost saving efforts net of the operating profit foregone from refranchising to boost FY09 U.S. operating profits by about $30 million.

Yesterday’s announcement signals that YUM is proceeding with its U.S. cost reduction plans, which is a welcomed sign because the U.S. still accounts for about 40% of the company’s expected 2008 total operating profit. Outside of these expected cost savings, however, a return to U.S. profitability still relies on several questionable factors: improved commodity costs; profitable same-store sales growth (difficult in today’s highly promotional environment); the success of Kentucky Grilled Chicken and a turnaround at KFC; and the credit market’s impact on YUM’s refranchising efforts.

KSWS: What Happened to Capitalism?

When I saw that KSWS announced a special $2/share dividend it made me scratch my head. Near-term payout trumped capitalism in a big way here.

During last week’s earning call, management stated that “the brand has slowed down and it needed to be ignited” – I agree. Utilize the balance sheet with $290 million in cash and drive growth by investing in new product initiatives -- or better yet put on the capitalist hat and go out and acquire one of the many troubled assets out there on the cheap. Instead, the Board paid out 24% of its cash in a special dividend. And the winner is… CEO, Steven Nichols.

As of June 30, the Nichols Family Trust owned 7.4 million shares or ~ 20% of the total shares outstanding making them the largest shareholder of KSWS stock (see table). As such, Steven Nichols would pocket ~$15 million. Nichols also owns substantially all of the class B shares (93%), which are super voting and account for ~70% of the total. How’s that for raising personal capital without sacrificing control of the company?

I don’t want to come across as too harsh here, because a rally in KSWS today will make some stockholders very happy. I like when stockholders are happy. But I like it more when management teams put the 5-year plan ahead of the 5-week plan.

Casey Flavin

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Don't Stress

“Sharp downward movements do that… they focus the mind… like a good hanging used to in the old West.”
-Judge Roy Bean

After a sharp three day -8.5% hanging of the S&P500, those who have been staring at the trees for the last 12 months have their eyes wide open now, don’t they? They wake up in the mornings surprised that a company that makes ¾ of the world’s computer chips is seeing demand slowing (Intel). They are running around talking about Great Depressions. They are coming to the stupendous revelation that my calling Hank “The Market Tank” Paulson onto the accountability carpet had merit.

Today is just another day in my life. Feet on the floor at the same time; banging through the macro factors in my trusty investment notebook; and now dealing with the same disbelief that I had to fend off at this time in 2007 that the market could actually go down a lot, by suggesting it has upside! If you don’t take the time to laugh at yourself in this business, you may as well just lock your door, tell yourself how smart you are, and cry.

An American alternative to isolating yourself is to just go to the bar. Roy Bean was a good ole Western saloon keeper who was born in 1825 in Mason County Kentucky. He was also “Justice Of The Peace”, and we may have to revive the old legend’s court alongside the Rio Grande to deal with the pending crisis of fear on Wall Street. You see, a lot of people can only justify 2 and 20 when they can lever up in bull market tapes… when the piano players music stops, the finger pointing starts, and the guns of narrative fallacy emerge.

According to FBI figures, in the week of November 3-9 (Obama’s election week), the Bureau received 374,000 requests for background check on new American gun owner purchases. A 49% year over year increase is a lot of firepower! Roy, this fear stuff is getting serious… in the last 3 days of the Street’s typical “he said, she said” ramblings across the crackberry network, I’ve “heard” of some snarly looking “hedgies” who are locked and loaded.

It’s time for real investors to stop the panting and get real here. If you are liquid long cash, this is turning into your second chance in two weeks to buy yourself some of the Street’s wares on sale. Why is it that Wall Street’s manly capitalist savants like to buy everything else in life on sale other than stocks anyway? Maybe it’s because they fear their wives shopping disruptions more than fear itself? Maybe it’s just because they fear their investment process – shouldn’t they?

Not all “hedgies” are crackberry addicts – some of them are doing a fantastic job managing risk and making money for their clients in 2008 - John Paulson, Bruce Kovner, Peter Thiel, and Phil Falcone are some of the new leadership names to add to your notebooks. Today, the Hedge Fund industry’s elite will be testifying in Washington. Undoubtedly, on their breaks, they might just call into their respective trading desks and buy/cover a stock or two down here.

Not one of the 9 bullish macro factors that I highlighted in yesterday’s strategy note has changed materially enough in the last 24 hours for me to change. In fact, some of them have improved on a day over day basis. The yield curve has steepened further, and LIBOR rates are lower (2.13% 3 month rate). Commodity driven inflation dropped another -2.4% yesterday with the CRB Commodities Index hitting fresh lows and Oil testing $56/barrel. There were many days in 2008 where CNBC’s finest would trumpet $3/barrel drops in oil as “stimulus for consumer spending”… today, with oil -60% lower, and oil dropping $3, I hear nothing but crickets. Can someone send them entertainers a calculator and a Research Edge math challenge? (Question #1: Is $3 /$130 a larger % change than $3/$56?)

I know, I know… Keith, ‘you’ve been buying stocks this week and you’re buying them lower today – shame on you… don’t make fun of us… you suck too’… I have to admit, with all of the people out there proclaiming their mystery of investment faith that “at some point fundamentals will matter” and/or “I’m a long term investor”, buying in a 12 day window for the first time in 12 months is a little reckless… God forbid someone gave me one of them guns!

Although Asia sold off last night (Japan -5.3%, India -3.1%... we’re short both), China slapped the drunks upside the head and said “I’m your Huckleberry”… closing up an impressive +3.7% on the Shanghai Composite Index to 1927. If you have a technician in your saloon, wake him up and send him that chart – it’s breaking out. Was China’s export report worse than expected? Of course it was – ASIA HAS SLOWED – this is not new… and if I didn’t make that call on a weekly basis nine months ago, I would actually feel as bad as Goldman should today trying to tell you it’s time to buy the Japanese Yen (short that call).

More importantly, China’s economy is growing high single digits, and now its inflation rates have dropped to low single digits. Last night they cut taxes on almost 1/3 of their exports. Rather than getting freaked out by the Connecticut Cowboys and their guns this morning, tickle your fancy with this narrative reality: CUTTING TAXES, SPENDING $586B in STIMULUS ahead of a SEASONALLY STRONG Q1… no, this is not Ronald Reagan folks… nor is it Roy Bean… this is China.

I have taken our Hedgeye Portfolio Allocation model down to 45% cash… I have plenty of powder left to be firing up my troops with guns… but I’m more into the “Justice Of the Peace” thing these days – so I’ll pass on the fear mongering, and look forward to those Western blue skies of my trip next week to the office we are building in San Diego, California. Don’t stress, it’s time to invest.

Happy shopping,

Long ETFs

EWL –iShares Switzerland- Zurich Financial (EWL: 4.68%), the largest Swiss insurer, reported a 90% y-o-y Q3 earnings decline on write downs and US hurricane exposure and suspended a share repurchase program.

EWA –iShares Australia- Commonwealth Bank of Australia (EWA: 7.2%) shares lost 6% after the company announced that non performing debts will likely double to 0.52% of total portfolio.

EWG – iShares Germany –GDP numbers released today show the economy contracted by 0.5% q-o-q in Q3, the second successive negative growth quarter and the steepest decline since 1996.

FXI – iShares China – Industrial production for October increased by 8.2% y-o-y, the slowest rate of growth in 7 years.

EWH –iShares Hong Kong –The Hang Seng declined by 5.2% today to reach its lowest level since October 29 as selling pressure mounted for financials.

VYM – Vanguard High Dividend Yield ETF – Borrowers whose credit does not qualify for the Fed Window who still have access to emergency bank lines are choosing to access them instead of floating commercial paper driving CP volume to the lowest level in 2 years. Three month LIBOR rose for the first time in 24 days, increasing by 2 basis points.

Short ETFs

UUP – U.S. Dollar Index – Trade numbers today are expected to show a narrowing deficit.

EWW – iShares Mexico – The lower house of congress approved a Federal Budget that factors a deficit of 1.8% of GDP, the first budget deficit in 4 years if approved by the Senate.

EWJ – iShares Japan BOJ Board Member Seiji Nakamura delivered a grave assessment of long-term Japanese economic conditions at a speech in Matsuyama today.

IFN – The India Fund – The Wholesale Price Index declined to 9% y-o-y for the last week of October marking the most rapid decline in inflation in 18 years.

Keith R. McCullough
CEO & Chief Investment Officer

What A Croc

Classic case of cocky brand mgmt gone bad. But my bear case liquidation analysis blesses current $63mm EV even if the brand is worth zero. Barring major fraud, I think CROX will be bought.
The volatility in this stock over the past two weeks told us that something big was coming down the pike. In that regard CROX did not disappoint. I won’t drone on about sales weakness, downsizing or asset writedowns. Ron Snyder (CEO) summed it up with two of the weakest statements I have heard from a CEO – ever.

1) “After several years of rapid expansion, highlighted by triple digit sales and earnings growth, our business has slowed during 2008.” Gee, thanks for that insight Ron.

2) “Our performance was below expectations and continued to be impacted by the extremely challenging retail environments in the U.S. and Europe during the third quarter.” Are you kidding me??? How a company with the trend characteristics of Crocs has the audacity to mention a ‘weak retail environment’ simply blows me away.

Ok, I got that off my chest. Thanks for listening. The question from here is bigger than the quarter, the restructuring, etc… The reality is that after hours, this stock is trading at $1.13. With 82.8mm shares, and 31 million in net cash, we’re looking at a total enterprise value of $63mm.

The market is saying that the $312mm book value is nowhere close to being real. I’m inclined to agree. But assume the following…

1) All stated liabilities are fairly represented, but that they head 20% higher over 2 quarters as the business continues to erode.
2) All $40mm in intangibles are actually worthless.
3) PP&E is only worth 50% of stated value.
4) Only 75% of accounts receivable are collected.
5) Remaining inventory is liquidated at 50% off.
That all nets out to $50mm, or $0.60 per share in value. This equates about 53% of the market cap – which unfairly assumes that the brand goes away.

Don’t forget that Crocs is a brand. Do I wear them? No. I think they are hideous. But I am not the customer. Even customers that have moved on still remember the name – and the reality is that Crocs has had reasonable success extending into areas beyond the core product, and the name is worth something. At $63mm, we’re getting pretty dang close. Unless there is fraud, this thing will be bought.

PS: I think I just spent too much time analyzing a $100mm market cap company!

EAT – What is plaguing EAT today?

In October 2008, Moody's and Standard & Poor's placed Brinker's credit ratings under review for possible downgrade prompted by the company’s revised earnings expectations for fiscal 2009. Standard and Poor’s has since left EAT’s credit rating unchanged at BBB- (investment grade) with a stable outlook. Moody’s review, however, is ongoing and is focused on EAT’s ability to improve operating performance and debt protection metrics over the next few years.
As a result, EAT’s availability under its $150 million uncommitted credit facility declined to $50 million. If the current rating is confirmed, the availability under this facility will return to $150 million. However, if EAT’s rating is downgraded by Moody’s, the company’s uncommitted credit facilities totaling $250 million will no longer be available. EAT has said it is committed to maintaining its investment grade credit rating and is taking actions to ensure its current investment grade rating is reaffirmed. The review and subsequent outcome will not have any impact on EAT’s availability under a separate $300 million revolving credit facility.

As of last week, EAT expects to receive net cash proceeds of $125.5 million from the sale of Macaroni Grill in fiscal 2Q09, excluding fees and expenses associated with the closing of the transaction, and will use the proceeds to pay down debt. In addition, EAT is significantly reducing capital expenditures for fiscal 2009, eliminating nearly all growth capital spending in fiscal 2010 and is suspending its share repurchase program.

Time will tell…

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