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During the late 1990's, as CBRL endeavored to maintain its strong, historical rate of growth, a number of issues lead, to a deterioration in the company's financial performance. Increased capital spending strained the CBRL system! More importantly, aggressive menu pricing and tight management of restaurant expenses threw the consumer value out of balance. The decline in operational performance, coupled with declining customer counts caused a significant decline in profitability.

As seen in the chart below the same management team is aggressively raising prices again! At a time when the typical CBRL customer can't afford to fill his tank with gas!

2Q08 EPS quality looked suspect.....
CBRL posted sluggish revenue growth of 3.6% in 2Q08. As expected higher operating costs caused restaurant operating income to decline 1.6%, but a 12.9% decline G&A versus last year enabled operating income to increase 7.5%. The balance of the EPS growth in the quarter was driven by a $0.05 per share gain on sale of real estate and a 34% decrease in outstanding shares outstanding.

Given the current traffic trends there is a high probability that 3Q08 EPS will look ugly too.....

Oh Canada... Doh!

Sticking with our theme of the GIL CEO's superior 'capital avoidance loss radar' we'd note the following...
  • 1) The percentage of shares held by Canadian institutions accelerated in the back half of 2007, coinciding nicely with the 3.6m shares sold by (Canadian) CEO Chamandy.
  • 2) By the end of December (when stock sales were complete), all analysts still covering the stock today had a Buy rating, and price targets peaked at $48.

Danger Zone

With earnings season about halfway done (brands reported, but retailers have not) we've got a pretty good sense as to where the industry stands. It's not pretty. Sales are off, inventories and high, and margins are down. (Thanks McGough, tell me something I don't know). We know this is painfully obvious to just about everyone that watches the tape, but what might not be as obvious is how bad the industry is on top of increasingly easy compares.

The chart below show shows the spread between sales growth and inventory growth on the vertical axis, and the yy change in Gross Margin on the horizontal axis. The sample includes every publicly-traded company that makes, designs or sells apparel. The place to be is in the upper right-hand quadrant, where sales are growing faster than inventories, and margins are up. On the flip side, retailers never want to be in the lower left quadrant -- inventories growing too fast relative to sales and Gross Margins down.

Unfortunately, we're in that lower left quadrant today. Even more unfortunate is that 1Q is the first quarter of easy compares vs last year in the current cycle. Bulls might argue (correctly) that any move out of the lower left quadrant is a positive stock move. We'd note that K Mart was there in almost every quarter for the 5 years before it went under. Sears and Foot Locker are there perennially.

Importantly, over the past 5 years, the apparel industry was to the right of the vertical line (margins up) almost 90% of the time. This was the tail end of the multi-year margin tailwind we think is going away. We have no reason to think that the current quarter is an aberration in any way vis/vis what is yet to come in this industry.

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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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