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Surprising Read on UA Trainers

Under Armour's much anticipated cross-trainer launch did not break any sales records last week -- by a long shot.

Our contacts suggest that initial sell-throughs were around 10% in the mall (i.e. mostly Finish Line). Fyi, 'sell through' refers to the percent of allocation sold through in a single week.

The surprising aspect of this statistic is that it is actually above the 6% we're seeing in some major sporting goods retailers. We'd think it would be the opposite given UA's stronghold in the sporting goods channel.

These are not disastrous numbers by any means, and we certainly won't judge the success of UA's footwear initiative by a mere week -- or even a full season. In fact, these numbers are pretty good in the context of such a weak retail environment.

But let's not forget that UA's initial launch of its cleated footwear business last year sold through at a rate of about 20-30%.

Such a wide divergence is simply too great to ignore.

The Bottom of the Boot?

It's tough to call the precise bottom in any business cycle - particularly in the fashion realm. If you were to walk into the Research Edge HQ, you'd see quickly that no one here comes even remotely close to having a viable opinion on fashion (except Mick, our eccentric VP-Brand design). Fortunately, we don't make fashion calls at Research Edge. We'll leave that up to the sell-side. We dig deep into industries, companies, balance sheets and business models. That's where we think there are a couple of interesting call-outs on Timberland.
  • 1) First, the bad news. Anything remotely resembling strength in the brand is coming at the family footwear channel - hardly a sign of regaining traction with real brand influencers. In addition, with the initial push into more fashion-forward product almost a year ago having fallen flat on its face, our read is that TBL has pulled the good 'ol retail one-eighty. It went from experimental fashion to ultra safe basic product. In that context, TBL is not taking up any prices (because it lacks brand strength to do so) despite higher input costs. There's very little to get excited about here.
  • 2) But here's what piques our interest. A) Our read from retail is that inventories are very clean. B) While average selling prices for TBL's boot business is down per NPD, the trend is hitting higher lows. C) Market share is still off, but at a materially lower rate than in at least 8 quarters. D) Surprisingly, the strongest channel aside from the family retailers is the department stores. A brand performing well there has got to be doing something right.
  • 3) Gross margins are still under pressure - which is no secret. But what's misunderstood is that TBL's gross margin pressure for the past 3 years has been magnified by a factor of 4 on the EBIT line. In other words, SG&A investment went up instead of down when things got tough, and TBL took it on the chin when it could have otherwise cut muscle to print a better number. We like TBL's course of action. That's a big lever to pull when things get tough. TBL is starting to pull it.

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.

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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.



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

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