Apparel: This ride is far from over.

What do semiconductors, toys, and footwear have in common? They've all been nearly 100% fully Asian-sourced since the late 1980s. Where is apparel different? An arcane protectionist system favoring the now-defunct US textile industry resulted in 60% of all US apparel consumption being sourced here in the US until 1994. Then the system was gradually pulled back, and the import penetration rate went higher, and higher, and higher. This has helped the margin structure of the industry more than just about any management team publicly admits. It is not difficult to build to an outcome where apparel profits do not grow for another 3 years.
  • The double whammy. The cost differential in manufacturing a garment is about 15 to 1 domestic/offshore. This was a clear boom for the US apparel industry. But people often look past the impact on existing import prices during an excess capacity/deflationary input cost environment. Factory owners locked up multi-year deals with US brands and retailers at fire-sale rates to ensure factories did not run idle. The bottom line is that 2-3% annual import price reductions combined with a 3-point average annual increase in the import ratio resulted in unprecedented cost savings for the industry. Our math suggests about $4-5bn, or about 3 points of margin per year.
  • Where'd the money go?? About 70% of the cash was passed through to consumers to stimulate demand. The other portion padded industry margins. The key call-out here is that pricing came down, per capita consumption rose dramatically, and margins went UP. We can't find many examples in other industries where pricing comes down and margins go up. This industry had lots of cake and ate it all.
  • Now what? 1) The import ratio just hit 99%. Ouch! Not much room to go there. 2) Apparel import costs are rising at the greatest rate since 1992. Unless oil is going back to $50, this industry has a lasting problem. Ouch again!

GIL: Ok, the market finally gets it...

Gildan finally had its day of reckoning. A nasty preannouncement on April 29th sent the stock down 37%. Not a shocker to us (see our comment from the day before) that the rationale is slower sales growth, weaker gross margins, and higher SG&A. Not a good concoction for a stock that was trading at 22x EBITDA and universally loved by the Street.

The timing bugs us. 2 weeks prior, Barron's ran a positive story (citing management) which highlighted the growth, but glossed over the risks on the cost side of the equation. The bigger timing issue is the 3.6mm shares that CEO Chamandy sold in 4Q for $147mm. We don't have a huge problem with executive stock sales - as it is within their right to diversify in a prudent and responsible fashion. But this sale was near the top, and just as pressures in the businesses started to build. The $147mm in proceeds is one thing, but the $70mm in loss avoidance is another. We wish the investing public at the other end of the trade had the same insight.

YUM - The U.S. Appears To Be in a Secular Decline

  • YUM's U.S. business has performed poorly and management does not hold out any hope that things will improve anytime soon. Management echoed previous commentary regarding its disappointment with the U.S. business, and it also seemed to indicate that a fundamental improvement in trends would not occur in the near term, given that many initiatives will be rolled out over '08 and well into '09. Consistent with continued negative same-store sales growth, U.S. EBIT continues to decline, despite the resilience of a highly franchised model.
  • Recently, management suggested that it is looking to mirror MCD's success by leveraging its current asset base, with more innovative menu offerings, daypart expansions (breakfast, late-night), and an even better value proposition. Many of the new offerings (Taco Bell's Fresco Healthy Line, Pizza Hut's Tuscani Pastas, and KFC's Grilled Chicken) appear enticing, yet will take time to roll out across the system. In our view, the new product pipeline does not address the structural issues associated with an old out-dated asset base.

Early Look

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YUM - Global Growth But Dependence on China Grows!

Yum has several attractive attributes making it an appealing investment vehicle: international opportunities, the Dollar doldrums, and significant cash to return to investors.

Yum's China division operates the leading chain restaurant company in China

CKR - P3 Same-store Sales Trends

  • We estimate that both concepts are running better than 3% pricing. P4 comparisons are easy for both chains.
  • Carl's Jr has seen a nice rebound despite its California concentration.
  • Hardee's is clearly experiencing a slower sales environment.

CKR - Trying To Understand G&A

The number one topic shareholders want to talk about when it comes to CKE Restaurants is the company's cost structure, especially G&A. Since we are awaiting CKR FY08 proxy, we thought it would be a good time to focus on compensation trends for CKR's senior management.
  • We believe that investors have a reason to be concerned about the level of G&A spending at the company. As seen in Chart 1, since 2002 CKE restaurants system-wide store count has declined by 8.2%.
  • The company has stated publically that its incremental spending in G&A per store is around $20,000 to $24,000 per year. Therefore, given the decline in the system-wide store base, G&A should be $5-7 million lower form the levels seen in 2003.
  • Despite the system-wide store count declining by 8%, G&A per store has increased 39.8%

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