Apparel Capital Deployment Famine

Capital deployment is like feast or famine in the apparel industry, and the supply chain starved.

If there's one thing I am convinced of it's that for a company to thrive in what will be a dramatically different operating environment for the next 3-5 years, the brand/retailer needs to invest in its content - big time. Whether it manifests itself in capex or SG&A depends on the specific business model (retailers need more capex while 'brands' need more SG&A).

Another key backdrop for me is that a company in this space could literally earn whatever it wants to for a few quarters. Maybe even a few years. Not tough to defer lease liabilities, and take down opex to boost margins today and borrow from 2-3 years out. EPS does not equal economic reality.

Consider the following...
  • The first exhibit shows the year/year change in gross margin for the apparel supply chain versus its SG&A ratio. In other words, it shows how much the industry is reinvesting back into sales, marketing, product, and the retail experience in different gross margin cycles. Noticing anything?
  • First off, it's pretty tough to miss that gross margins were up pretty massively over 7 years. That's right in line with my industry call (i.e. this tailwind will reverse).
  • Second, is it just me or has the yy change in the SG&A ratio consistently coming down? I don't know about you, but when I look for a good business, I like to find one that takes gross margin improvement and reinvests a fair share into SG&A to drive future growth. This industry has done the polar opposite.

Key Commodity Trends

  • - From the Cattlenetwork - Cattlemen's attitudes were bullishly positive! Drought, hay shortages, and row cropping has forced breeding stock off their range over the last year and a half and the results of this herd reduction are just now starting to show. Weekly feeder cattle receipts in last year's drought ravaged Southeast are already running 9 percent lighter than 2007 and this shortage should become even more prevalent as the summer progresses. Research Edge translation - beef prices are going higher for the balance of 2008!
  • CornThe CEO of Pilgrim's Pride (PPC), Clint Rivers, spoke in NYC this week and said - "I think today the industry is thinking in terms of placing (chickens) for $6 corn when I think we should realize the potential for $8 corn is certainly there and I think we should be in a position to deal with that. PPC recently announced it was cutting production about 5 percent, largely due to higher feed costs. Research Edge conclusion - The restaurant industry to see higher chicken price for the foreseeable future.
  • WheatWheat

Gas Prices At the Pump vs. Restaurant Sales

The spike is gas prices in 2008 looks just like 2007.

Unless its different this time (thanks to the government stimulus program) casual dining sales trends are impacted by higher gas prices.

As a reminder, this is a small sample of what happened in the summer of 2007:
EAT lowered guidance in August.
PFCB missed in October.
CAKE missed in July
MSSR missed in September

I don't need elaborate any further...

Except, I should point out that the casual dining group is up 25% this year.

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EAT - To Have.... And Have not..........

To Have....
EAT - Brinker International
On a consolidated basis, Brinker's brands gained momentum in the first calendar quarter of 2008. Importantly, the core Chili's concept (excluding the impact of California, Nevada, Florida, and Arizona) comparable restaurant sales improved to 3.5%. For the last three quarters, Chili's has outpaced Knapp Track, the industry benchmark, widening the gap in the most recent quarter.

And Have not...
SNS - Steak 'n Shake
For the first calendar quarter of the 2008, SNS same-store sales declined 6.3%. Importantly, this consists of a decline in traffic of 8.8%, partially offset by 2.5% increase in average check. The increase in the average check was due primarily to a 4.0% menu price increase that was offset by higher redemption of coupons. The good news is that this is an improvement from a 9.5% decline in last quarter. The bad news is the conference call was a disaster and the company appears in disarray.
RT - Ruby Tuesday
Ruby's fiscal third quarter ended March 4, 2008 and the company reported company-operated same-store restaurant sales decreased 12.7%, while same-restaurant sales at domestic franchise Ruby Tuesday restaurants decreased 12.0%, versus a decrease of 1.0% and an increase of 1.8%, respectively last year.
CHUX - O'Charley's
For the first fiscal quarter of 2008, O'Charley's same-store sales decreased by 4.7%, driven by an 8% decline in traffic and a 3.6% increase in average check. Average check for company-operated restaurants in the first quarter was $12.97, including dinner.
Ninety Nine reported same-store sales decreased 2.2%, which was the result of a 3.8% increase in average check offset by a 5.8% decrease in guest counts. Average check for Ninety Nine in the first quarter was $15, including dinner.
For Stoney River, same store sales declined 3.2% in the quarter as an 8.3% increase in average check was offset by a 10.7% decline in guest counts. Average check in the quarter was $47.59.

SBUX - Part three of a three act play!

The drama that is about to unfold for Starbucks is a show that we have seen many times before. The three companies that come to mind first are Wal-Mart, McDonald's, and Coca Cola. The first act is played out by the dominant founder overseeing a tiny company through a very rapid growth phase into a dominant global brand. Act II begins to unfold when the market forces and the competition alters the competitive landscape, the first financial misstep happens, and the company's valuation collapses. At this point in the play, shareholders get very angry and demand change. The patriarch of the company is reluctant or slow to change, which is the beginning of the end. Usually, the drama ends with there being two or three CEOs before the company gets it right.

It was not long ago that I wrote about the company's dramatic downturn in its fundamental performance, and how it's likely to create issues that it never had before as a public company--shareholder activism. While it's a small position, Trian has filed a 13F on Starbucks. Trian also owns large stakes in Kraft Foods, Cheesecake Factory, Tiffany & Co. and Cadbury-Schweppes.

Why Starbucks?

First, the global growth potential for the Starbucks brand is enormous.

Second, I believe that the Starbucks brand would be a valuable addition to many different global food and beverage companies. If the financial performance does not improve soon, losing control of the company is a real possibility. Additionally, many private equity firms would love to own the company.

From this point forward, every piece of bad news means we are one step closer to some real drama.

WMT - Is WMT going after the restaurant industry?

According to the FT - WMT will be pursuing a passion for fresh and delicious food and the highest level of customer service in small neighborhood grocery stores. The 15,000 sq ft Marketside neighborhood stores will be dedicated to helping our customers answer the question 'What's for dinner?'.

Is this a restaurant meal occasion?

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