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Franchisees Are Really Feeling the Pinch

Papa John’s announced yesterday a number of proposed domestic franchise system support initiatives in response to the current economic challenges. These initiatives include:

1) Providing continued cheese cost relief to the system in 2009 by modifying its cheese pricing formula
2) Providing additional national marketing support in 4Q08 and FY09
3) Offering expanded royalty relief and local marketing support for struggling franchisees or markets
4) Convening a lender’s summit, principally of regional banks and other lenders, to educate them on the Papa John’s model with the goal of expanding credit availability to franchisees
5) Providing company loans to operationally strong franchisees to help them to acquire troubled franchise groups
6) Suspending the 0.25% royalty rate increase, which was scheduled for January 2009, in the first six months of 2009
PZZA estimates that the incremental costs of these support initiatives will be about $3 million in 4Q08 and $8-$10 million in FY09. The ultimate impact for 2009, however, will depend upon the actual number of franchisees who choose to accept the proposed support program. Although this type of support will broaden PZZA’s short-term exposure to the current environment, the company “believes the support program will produce long-term shareholder benefits by mitigating potential unit closures and strengthening [its] brand during these challenging times.” The need for these support initiatives highlights the fact that it is primarily the franchisees (across the restaurant industry) that are enduring the total profit impact from lower consumer spending, rising commodity costs and the tightened credit markets.

Franchisor financing of its franchisees is becoming the trend recently with more restaurant operators communicating the need to provide assistance in today’s environment. And, a prolonged downturn will likely force more companies to make announcements similar to that of PZZA. Domino’s said on its most recent earnings call that the company is “wading through uncharted waters and we are not going to let our A and B franchisees fail if there are ways we can be helpful with some short-term financial support and solutions.” Management went on to say that although it does not want to be a bank, it would provide some level of bridge financing to help facilitate the acquisitions of its weaker franchisees by stronger franchisees as the company would rather see a deal get done than a store closure. Domino’s would also offer some deferral of costs, royalties or other payments to a franchisee that is in turnaround mode if it would prevent that franchisee from failing. At the time Domino’s made these comments, it was only highlighting its options, but the fact that the company communicated them to the investment community signals that some of its franchisees were in desperate need of financing. That being said, I would not be surprised to hear how the company proceeded with these short-term financing initiatives on its fourth quarter earnings call.

Just yesterday, JBX announced that it provided bridge financing to a small number of franchisees in 4Q08 in order to get more of its company stores sold as the company is the midst of a massive refranchising program, which is being slowed somewhat by current credit conditions. JBX plans to accelerate the pace of its refranchising efforts over the next five years to reach its goal of franchised ownership in the range of 70% to 80% by the end of fiscal year 2013 (from 38% franchise ownership at the end FY08). In order to remain on target, JBX said it is comfortable providing bridge or mezzanine financing to its franchisees to facilitate the completion of transactions on a go forward basis.

As I said before, based on the likelihood of a prolonged economic downturn, I would expect more restaurant operators to announce financial support initiatives for their franchisees, including deferred royalty payments. Two obvious candidates are DIN’s Applebee’s franchisees and YUM’s KFC franchisees. A select number of Applebee’s franchisees are struggling to make ends meet and are aggressively cutting costs. Everyone knows the problems with KFC. Like many other restaurant companies today, KFC’s same-store sales continue to decline (down 4% in the most recent quarter) as costs climb higher. More unique to KFC, however, is the fact that the concept has been struggling from a profitability standpoint for the better part of the last two years so the current environment is only worsening an already difficult situation. At some point, franchisees are going to demand relief.

Oil: We now have a four handle

We discussed Oil on our morning call today. Our view have been consistently negative on the fundamentals of Oil due to the demand picture globally, we have also been of the belief that Oil should be set up for a bounce due to its oversold condition. While we have traded Oil successfully on the long side for some small gains this year, the trend is and continues to be down.

Oil as of today dipped below $50 per barrel (West Texas Intermediate), which is a three and half year low and more than 60% decline from the June 2008 “It’s Global This Time” easy money highs. In hindsight, which has become increasingly apparent, Oil, just like any commodity, will always retrace back to its marginal cost. The commodity has now fallen below its marginal cost, which was previously thought to be in the $60/65 range, due to shuttering of higher cost projects and a decline in services costs.

The culprit for the dramatic decline in the price of oil is both a massive deleveraging as large pools of capitals are forced to sell their commodity assets (the Harvard Endowment is one such example we have been hearing about) and weaker demand trends become reality. It seems that bullish news for the price of oil has no impact, as we noted in our last notes after OPEC announced production cuts. Earlier this week a group of Somali pirates (“Arggghh”) captured a Saudi Arabian supertanker and threatened a major transport lane and the market completely shrugged off the risk.


Hot on the heels of US inflation data, Japanese customs data shows that exports declined there by the fastest pace since 2001 as global demand dropped sharply for Japanese products. The speculation by local policy watchers is that deflation is back and that the BOJ will start taking action. We have all seen this movie before, deflation hammers the Japanese economy and the BOJ responds by slashing rates creating stagnation. Governor Shirakawa would have to cut the basic discount rate from 0.3%, actually 5 basis points higher than the starting point that his predecessor Hayami had to work with in 2001 but the outcome of any cutting from here lease to the same destination -next stop zero.

We are short the Japanese equity market and the yen via the EWJ & FXY.

Andrew Barber

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Putin’s Puppet Medvedev

President Dmitry Medvedev and Prime Minster Vladimir Putin of Russia’s United Russia party met before congress today to promise Russia would emerge stronger from a world economic crisis, one Putin purported was triggered by U.S. recklessness. Putin’s 45-minute speech, which trumped Medvedev’s much shorter opening remarks, provides further evidence that a return of Putin to the presidential “thrown” is highly probably.

Speculation about a possible Putin comeback first hit the wires on November 5th when Medvedev proposed extending presidential terms (not including his own current one) from four to six years, which Parliament approved on the second of three readings Wednesday. With the current constitutional limits of two consecutive terms, this recent reform will be used to justify holding early elections to return Putin back to his seat.

Tensions have escalated in recent months between Washington and Moscow over U.S. proposed instillation of 10 interceptor missiles in Poland to counter the likes of Iran. Further, the relative lack of response from US and EU officials to negotiate the remove of Russian troops following their invasion of Georgia in early August signals an increased inability of the international community to deal with dictatorial Russia.

Medvedev’s pledge of $200 billion in loans, tax cuts, and other measures might make a small dent in an economy that is expected to slow to 3% growth next year, but it won’t shore up the financial trouble of an economy levered to oil, which just touched a three and a half year low of $51.12. Putin, who stepped down in May, may use the current vacuum of both economic and political leadership to return to power sooner than anyone expects.

Daryl Jones
Managing Director

Matthew Hedrick


The initial claims this morning came in at the highest level since 1992. Despite the fact that a significant increase was heavily anticipated by the market, the reality still has had a shock effect sending stocks down and compressing yields.

If you have been reading our work for any length of time you know that we have expected unemployment to reach 6 to 7% by year end as the pain continues to work through the system. With financial and auto sector layoffs picking up steam we face the real possibility that we will hit the uppedr edge of our range. If we get more signals in coming weeks that the job loss cycle is gaining momentum we may revise and recalibrate our models, but for now we continue to keep our eye on the tape and stick with our process.

Andrew Barber


Keith called in from the airplane while sitting on the Tarmac before takeoff with these levels. Our models indicate a broad buy/cover zone this morning between 790 and 818.

As always we remind anyone who is trading these levels intraday to keep stop losses in place in order to keep a trade a trade to stay in the game.

Andrew Barber

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