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All sourcing risk is not created equal

For those tracking the Asian environment, the chart below should be particularly relevant. With 85% of US footwear consumption being sourced in China, it's interesting to see each company's relative exposure. A couple of takeaways...

1) Nike very low at 35% and trending lower.
2) Adidas not too far behind at 46%
3) Payless and K-Swiss painfully high at 96% and 98%, respectively.

On one hand, Nike and Adi are materially underweight China, and could keep relative exposure low by increasingly dominating factories in Vietnam, Thailand and the Philippines.

But what does that mean for everybody else? In a zero-capacity-growth environment, it tells us that they'd better have incredibly relevant product and subsequent pricing power. Otherwise, margins could be at risk.

Free Food Day

Today we woke up to the news that McDonald's thinks consumers who try its new Southern Style Chicken Biscuits and Sandwiches will come back for more, so it's giving them away on May 15--with the purchase of a medium or large beverage.
  • This picture was taken at Dunkin Donuts on Whitney Avenue in New Haven, CT. - a short walk from Research Edge's HQ.
Apparently, Dunkin is feeling the pressure......

Supply Chain Math Does Not Lie

The footwear margin-share equation between the US and Asia seems to be hitting a tipping point. As noted in last night's "Macro Matters!" comment, with ominous signs of Asian governments taking up rates to contain inflation, it's looking like we're facing both higher costs AND slower growth. Why does this have particular implications for the footwear industry? Consider the following...

1) Over the past 8 years, margins for Asian manufacturers have gone down by 8 points. Margins for the brands have gone up by 8 points. Retail margins have been flat. There's only so much margin to go around, so the direct inverse correlation is no coincidence.

2) In the early 2000s manufacturers had around a 15-20% gross margin, which was more than enough to offset the roughly 10% in SG&A and capital costs to turn a profit. This was especially the case given that the Chinese government rebated the VAT tax, which added between 3-7% in net profit for the manufacturers. All said, life was good as a manufacturer, which is why capacity grew at a mid-single-digit clip. Excess capacity = more pricing leverage on the part of the front-end of the supply chain.

3) Now what? Gross margins are approaching the break-even hurdle, VAT tax rebates are being phased out to stimulate local consumption as opposed to export, and costs are headed higher across the board. The result? Capacity growth heading closer to zero.


4) The kicker. 85% of US footwear consumption is sourced in China. No joke. There are few industries that are so married to one country. That's risky business.

5) So what's next? We're convinced that higher prices for US footwear imports will continue on a multi-year basis. An inflection in an 8-10 trend is likely to take a while. This is when the winners will be companies with a) pricing power, b) global revenue diversification, and c) little dependence on Chinese sourcing.

Check out the chart below. It pretty much sums it all up.
Something's gotta give.



Early Look

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The WEN/TRY Deal...

Overview of the Transaction

Upon completion of the transaction, the new company is a combination of two national brands with over 10,000 restaurants in the U.S. and approximately $12.5 billion in system-wide sales. The Arby's and Wendy's chains are roughly 70% franchised. The Arby's system is roughly 3,700 units across the U.S. and Canada, and generates system-wide sales of approximately $3.5 billion. Currently Arby's has plans to open 50 company operated units and 100 franchised units in 2008. The Arby's system had commitments from franchisees to open almost 400 new units over time. Wendy's is the third largest quick service hamburger chain in the world with more than 6,600 restaurants and system-wide sales of approximately $9 billion.

The deal terms include Wendy's shareholders receiving 4.25 shares of Triarc Class A Common Stock for each Wendy's share they own. According to the Merger Agreement, the Board will have 12 members, including two directors nominated by Wendy's. Arby's and Wendy's will operate as autonomous business units headquartered in Atlanta, Georgia, and Dublin, Ohio, each led by brand CEOs. A support center headquartered in Atlanta will be created to manage all public company responsibilities and other shared services. Roland Smith will serve as the CEO of the parent company, as well as of the Wendy's brand. Tom Garrett will become the CEO of the Arby's brand and Steve Hare will be CFO of the parent company.
  • Re-energizing the brands - Revitalize the advertising message by focusing on the quality heritage created by Dave Thomas. Also, improve the new product innovation pipeline and expand dayparts like breakfast and snacks.
  • Improving operations and margins - Improve Wendy's store operations and margins by developing an ownership mentality at company-owned stores. Currently, Wendy's store level margins are more than 400 basis points below where they were six years ago. This could take as long as three years to achieve.
  • Shrinking the corporate structure - Management has identified $60 million in synergy savings. We can only imagine the bloodletting that is going to happen in Dublin. According to management, these savings will take approximately two to three years to fully realize.
  • In the world of M&A changes never come easy.....
  • Issue #1 - the restaurant industry rarely sees a successful M&A transaction. The turmoil that is created through combining the employees and the franchise system is draining and very unproductive. The risk of increased turmoil within the Wendy's system is even greater with Roland Smith, a Wendy's outsider, as CEO of the Wendy's brand. I do not believe that anyone outside the Wendy's system has ever managed the brand. It will take a special person to win the hearts and minds of the Wendy's system.
  • Issue #2 - Arby's has strong penetration in the Midwest, like Ohio, where the chain has over 300 restaurants. Wendy's, headquartered in Ohio, is also very strong in the Midwest. We believe that the restaurant industry is a zero sum game; it's likely that competitive issues will crop up among the Wendy's and Arby's franchise systems.
  • Issue #3 - It's very difficult to fix restaurant level margins in an environment where customers are strapped and food inflation is rampant. In addition, Wendy's biggest rival, McDonald's, is very well positioned and has lots of relative momentum.
  • Issue #4 - Both chains lost market share in 1Q08.
  • Currently pro-forma EBITDA for the New New WEN is around $350-$400 million in EBITDA.
Transaction Rational and Valuation Matrix

On Target

Ok, here's an odd one... WWD reported that Target and Barney's are teaming up on a brand/marketing initiative. Yes, that's the same Target that sells everything from kids' underwear, to Weber grills, to eggs, and the same Barney's that sells Prada. Now there's an eye-grabber.

Even more interesting is that Target is the one originating the content. Target is trading up in prestige, and Barney's is trading down big time. This is a limited run, limited distribution campaign on Target's exclusive Rogan Gregory line. It's not a big revenue event by any means. But it shows a couple of interesting longer-term trends.

1) The 'content vs distribution' play in this space is dying a slow death. No longer can Wall Street box these companies into 'retailers vs brands.' The premium brands are earning the right to become retailers, and as we see with Target, the more successful retailers are earning the right to be viewed as brands in their own right.

2) Owning the consumer relationship matters now more than ever. Both our opinion and fact-based analysis on the secular landscape for apparel is not for the faint of heart. As the global supply chain is squeezed and stress-tested to a degree greater than at any time in history, it is the brands and retailers that are pushing the envelope with innovation -- both in product and marketing -- that will come out ahead.

3) Those that are not investing today in order to stay above water tomorrow will sink at a rate faster than they can lower their own expectations (never mind the Street's).

Macro Matters!

'Yeah, macro might matter, but this industry has a mind of its own.'
That's the most common feedback we get as to why macro calls don't work in apparel/footwear.

As much conviction as we have in the disastrous secular outlook for softlines (see 5/5: This Ride Is Far From Over), we're getting even more concerned about where we are in the cycle. What? Getting MORE concerned after earnings tank and the stocks get clobbered?

Yes. And it's all about Asia. It's macro.

Since we've gone live with our portal, I've been having fun searching out relevant charts and pictures that help tell an investment-significant story. This time, I'm going to blatantly plagiarize from my colleague Keith, with whom I share real estate on this site. Check out the excerpt below from his morning comment posted early today (be sure to click on the image to enlarge it).

Here's a few other recent events worth considering...
* India inflation report came in at a 3 year high. Singh is prepping for '09 re-election with containing inflation as a key point on the agenda.
* BoJ reverted to a neutral stance in light of rising cost pressures.
* Pakistan/Philippines food crisis.
* Singapore Central bank guided down last week in terms of growth. Growth was 7.7% last year. Now guiding to 4.6%. Best case, by 2009 growth is cut in half.

So Asia, which has been the source of stimulus for increased per capita consumption in the US due to lower costs, is going to continue to take it on the chin. We've seen some of the cost inflation already, and we think that there's much more to come. But the double whammy comes when growth in Asia slows as well, and an important growth market for US brands eases.

Growth slowing AND margins contracting?

Scary.

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