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COLM Into 4Q: It's All About Duration

Keith and I just had a healthy debate on COLM. I think it’s shaping up as a fundamentally positive risk/reward. His near-term inclination is to wait for the print. It comes down to duration.

Why I’m Liking COLM.
This is a perennially underperforming business – for good reason. It managed the transition from a small family-run specialized model into a larger mass-market portfolio of brands while tightening its wallet and starving its content of dollars needed to grow. As such, a host of brands including The North Face (VFC), Spyder, Marmot, and dozens of others have been nibbling away at its share. COLM has maintained a decent-enough top line growth rate overall, but margins came down to 10% from 20% 5 years ago as it lost relevance and ability to hold price.

But at the beginning of last year, COLM started to plow more capital into its brands – both R&D and marketing – and is finally putting capital to work in growing its footwear business. For the record, COLM has only a $200mm footwear business – which is a joke when considering that it owns brands like Columbia, Sorel, and Mountain Hardware. Just because it had 20% margins once it does not mean it is owed them again. In fact, COLM grossly over-earned then. But I think that the resources are finally being put in place that will prove this to be a margin level from which COLM can climb. All we need is flat margins and this name works. I can find a point or two of upside.

As for the business, it goes without saying that it is not good today. But with 1) the Street expecting a 50% earnings decline in the quarter, 2) a 5% earnings slip for 2009 (the first time ever that COLM went into a year w down Street expectations), 3) only 1 buy rating on the stock, 4) 35% of the float short the stock, and 5) trading at 4.5x EBITDA – I think that the results and outlook need to be really really bad for this stock to tank from here.

Fundamentally… Yes, I am concerned that the top line compares for the next 2 quarters are tough as COLM anniversaries a 4-5% FX boost, as well as the launch of Techlite and Omni-Shade – which is represented in the -11% spring backlog already reported. This should be offset in part by sales from the additional 15 outlets in COLM’s plan. Margins, however, go up against extremely easy comparisons (-4-6pts last year) in 1H at the same time it will be benefitting from the $7-$8mm from recently-announced headcount cuts. Some of this will go to additional lease expenses, but the reality is that there’s never been a better time to negotiate with landlords. I’m usually not a fan of new stores for brands like this, but the timing lowers the sales hurdle needed to leverage occupancy costs over the long-term. Finally, I loop this into what should be a decline in capex for ’09, and inventory relative to sales (see SIGMA chart below), and this all adds up to be a pretty nice story in this tape.

Oh, and by the way – inventory of cold weather gear is not exactly fat out there. After a string of mild winters, it’s been very cold in key regions of the US relative to past years. I hate bringing up the weather card, but it has always been a factor here, and that fact remains.

This company has a lot of wood to chop, but for every negative fundamental factor, I can come up with two positives. It is not a 'big idea' for me here, but the risk/reward can't be ignored.

HOT: EXPENSE NOW, SAVE LATER

HOT’s fundamentals are worse than we thought yet guidance was better. While 2009 EBITDA guidance was worse than the Street it was much better than our estimate by about $100MM. This happens to be the amount of cost savings indicated by the company.

While we are impressed by the cost cutting progress HOT management has made, our enthusiasm is tempered by the timing and categorization of expenses. In Q4 HOT recorded “non-recurring” charges and expenses of $350-400MM offset by a gain on asset sale of around $175 million. Some of these expenses will clearly benefit 2009, making the margin gains somewhat suspect. The initial reaction of investors may be to push the stock higher due to less than toxic guidance but the stock is not cheap, the underlying fundamentals are much worse than the guidance indicates, and estimates are likely to continue you to come down.

The following are some of our observations:

• The fundamentals are awful in lodging and timeshare
• HOT continues to beat and lower guidance, a trend we expect to continue
• Timeshare write downs totaled $101MM – Q4 timeshare margin was 45%, around 20% higher than normal. The write down will likely continue to benefit margins and the margin gain is reflected in guidance. However, this does not change the economics at all.
• Q1 guidance is much worse than full year – It looks like HOT is banking on a 2nd half recovery which won’t happen.
• A deferred gain on sale of assets of $27MM is likely included in 2009 guidance as fee income, which already includes $83MM of amortizations of deferred gains from 2008
• The stock looks like it is trading over 9x EBITDA which is not cheap, particularly since some of the margin improvement (especially timeshare) is not sustainable.

SBUX – WHEN IS ENOUGH ENOUGH?

It was a little over a year ago that SBUX first announced Howard Schultz’s return to the CEO position and the company’s new transformation agenda, including slowing the pace of U.S. growth and closing underperforming store units, to renew its focus on store-level unit economics. There was much anticipation for the 1Q08 earnings call that followed shortly after that initial announcement to learn the magnitude of the changes. On that 1Q08 call, SBUX reduced its 2008 U.S. new unit opening targets and announced the closure of 100 underperforming stores. Additionally, the company said that it would open less than 1000 stores in the U.S. in 2009.

Here we are one year later and SBUX has since increased those 100 expected closures to 961 with 800 in the U.S. (384 of which are already closed) and 161 internationally (including the 61 stores that have already closed in Australia). Regarding new unit growth, SBUX now expects a decline in net new stores in the U.S. in 2009 following all of the expected closures. Unfortunately, these significant downward revisions to store growth and store closures did not come at once. Instead, we have had to agonize through these additional cuts each quarter since the transformation agenda was announced. I thought SBUX’s initial announcement last January was reactionary as comparable sales trends had already started to decelerate and yesterday’s revisions are once again reactionary. That being said, no one expected this quarter to be good. We did not need CEO Howard Schultz to remind us that unemployment, jobless claims and the number of housing foreclosures have increased while consumer confidence has fallen to an all-time low to know that.

Even if the announced changes continue to be reactionary, they are the right moves for the company going forward, and they prove that CEO Howard Schultz is willing to make the difficult and necessary decisions to improve SBUX’s profitability. The fact that Mr. Schultz said he has a “Plan to Win” (MCD called its 2003 turnaround plan the “Plan to Win”) and that SBUX is going to begin offering some type of value breakfast combo meals at a national price point in March show that he no longer thinks SBUX is immune to the issues facing his competitors.

And, these store closures, slowed unit growth, headcount reductions and increased focus on managing costs are already yielding results. Although same-store sales declined 9% on a consolidated basis (-10% in the U.S. and -3% internationally), the company’s EBIT margins improved on a sequential basis to 8.3% in 1Q09 (excluding restructuring and impairment charges) from 4.5% in 4Q08. Although margins declined nearly 380 bps YOY, an 8.3% margin is not a bad number for a restaurant company in today’s environment. Yesterday’s, we also learned that the company is expecting to yield an additional $100 million in fiscal 2009 cost savings, primarily from additional reductions in non-store positions and store closures, bringing the total expected savings in fiscal 2009 to $500 million. Margins should improve throughout the year as the company’s savings are expected to ramp up in each subsequent quarter from $75 million in 1Q, to $100 million in 2Q, to $150 million in 3Q and $175 million in 4Q. The comparisons get significantly easier as we trend through the year as well.

Predicting when SBUX’s top-line results will improve is much more difficult. These comparisons also get easier but easy comparisons no longer seem to matter when it comes to same-store sales growth in this environment. In the short-term, investor sentiment will be influenced by SBUX’s top-line results, but the company is now well-positioned for the long-term and is managing the aspects of its business it can control. We have already seen an improvement in margins and the company’s current cost initiatives are expected to lead to increased savings in 2010 and beyond. It should also not go unnoticed that even with comparable sales down 9%, SBUX generated over $100 million in free cash flow in the quarter, which on an annualized basis is a 6% cash flow yield, also not a bad number in today’s environment.

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HOT: THE CREDIT IMPLICATIONS OF OUR FORECAST

Yesterday we posted a note “HOT: THE MOTHER OF ALL ESTIMATE CUTS” discussing a potential 50% earnings cut in 2009 consensus estimates. In this note we address the credit implications of our projections. If our numbers are close to being correct, Starwood will likely violate its 4.5x Consolidated Leverage covenant in the 2Q09 and certainly breach this covenant in the 3Q09 when Consolidated Leverage could peak at 5.2x.

Despite the breach, bondholders shouldn’t necessarily lose a lot of sleep over Starwood’s credit situation. Although a covenant violation is never ideal, at approximately 5x leverage the banks will give Starwood an amendment (6th time on this facility) and simply increase their thin credit spread to something more juicy. At our TTM Consolidated EBITDA calculation of $765MM at 3Q09 and only $1.9BN at the bank and secured debt level, the banks are also sleeping well at night knowing that leverage through their paper is only 2.5x.

A shareholder, however, shouldn’t sleep so soundly. If HOT breaches, cost of borrowing will skyrocket and EPS and cash flow will go down, again. The company does have some trophy assets that could be sold but the number of potential buyers has dwindled. It’s not exactly a seller’s market. Buying back discounted bonds is also an option to help de-lever.


HOT must do something to avoid a Q2/Q3 covenant breach

EYE ON AUSTRALIA: CPI

The Bureau of Statistics released Q4 CPI data today, with a -0.3% quarter-over-quarter level that confirms the trend indicated by last month’s Melbourne Institute Inflation Gauge data. This confirmation sets the stage for Governor Stevens to cut rates sharply when the Reserve Bank’s board meets next Tuesday.

Australia is now showing clear signs that it is slipping into its first recession in two decades, after the economy grew 0.1% in Q3. Currently the mood down under is growing increasingly grim with consumer confidence declines in January and a business sentiment index level for December that marked the twelfth consecutive decline. A two-year high unemployment rate of 4.5% is expected to increase over the next two quarters.

Currently median forecast come in at a cut of 100 basis points, taking the benchmark rate down to 3.25% while leaving Stevens with several bullets left to use. We continue to think that Stevens and his team are doing an admirable job –but the external issues faced by the Australian economy cannot be overcome by deft policy alone.

Matthew Hedrick
Analyst

Andrew Barber
Director

EYE ON THE IMF

The IMF released its updated “World Economic Outlook Update” today, with revised global projections for 2009 and 2010. In it, IMF Chief Economist Olivier Blanchard states bluntly, “we now expect the global economy to come to a virtual halt.” While our macro view is not as bearish as Blanchard’s holistically, we questions if some estimates are padded, in particular India.

A few main call-outs from the Report: World growth is projected to fall to 0.5% in 2009, the lowest rate since WWII, a downward revision of about 1.7% from the November 2008 WEO update, with a gradual recovery projected in 2010 to 3%. Advanced economies are expected to suffer the deepest recession with a 2% contraction this year. Inflation is expected to fall to 0.25% in 2009 from 3.5 % in 2008, before edging up to 0.75% in 2010. Emerging and developing economies are expected to slow from 6.25% in 2008 to 3.25% in 2009, with inflation in these countries expected to decline from 9.5% in 2008 to 5.75% in 2009 and 5% in 2010.

We took special note of the projections for India: at 5.1% the IMF projection for growth is well below the 6.5 - 7% that the ministry of Industry has been hyping in the press, but still strikes us as very optimistic. We re-shorted the Indian equity market via IFN today and continue to think that growth could slow more than many expect there.

The graph below taken from IMF data presents country specific, commodity, and import/export forecasts for 2009 juxtaposed with predictions from their last report in November.

Matthew Hedrick
Analyst

Andrew Barber
Director

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