Salt in the Wound

My Research Edge colleague on the ground in China just fed me an interesting tid-bit regarding the lingering impact of the quake on Chinese footwear production. Recall that the initial read from our sources in China was that production was not directly impacted, but that raw material delivery flow was in jeopardy.

A new challenge is brewing, however, with more far-reaching implications. Consider the following.

1) Most factories have a static number of workers in any given month to fill roughly 50-60% of maximum capacity. Then they fill the remainder with migrant workers when seasonal demand kicks in.

2) Peak production takes place in the summer in order to ship in July/August and sell at retail in August/September. That means that we're just hitting the most important part of the demand cycle for such labor. (You probably see where this is going...).

3) Due to the quake, many migrant workers are not reporting to factory-duty as employers expected (a recent comment by a factory owner employing 40,000 people confirmed this). Pouring salt in the wound, such workers already on the job are walking away in order to care of family members who are homeless. As a frame of reference, the latest figures for homeless in China are hovering around 12 million -- that's the equivalent of nearly half of Canada.

4) Yes, everyone talks about the 'China cost pressures' theme. But I'm willing to bet that 2H COGS pressures for the footwear space spike up again. Someone is going to have to fund this. It's probably not you and me. And it's probably not the big brands (though they'll feel some pain). My sense is that retail margins take it on the chin. Check out my 'Supply Chain Math Does Not Lie' post from last week to see why I think that the margin squeeze will hit retail.

5) Lastly, the migrant worker shortage just months after the biggest blizzard in Chinese history is serving as something of a one-two punch. The industry trend had been to push production into the central part of the country to side-step cost inflation. But the blizzard exposed a weak transportation infrastructure, and the migrant worker challenge is likely to be an issue for all of 2008.

I've used this statistic a dozen times, but it's an important one. 85% of our footwear consumption comes from China. By my math, a $60 shoe at retail will see between $2-3 per pair of higher costs. That translates to 3-5% price increase at retail just to cover the higher costs. Don't hold your breath there. It hasn't happened in well over a decade.

Keep an "Eye" on this one folks...

COLM: 2H Margin Pop?

Columbia Sportswear cut headcount today according to SportsOneSource (I've found them to be fairly accurate on nuggets like this). While I don't make it a practice of commenting on news stories like this, I have to point out a few important themes.

1) Based on my sources, the report appears true, and seems to be above and beyond any cost reduction efforts the company noted on its recent conference call.

2) This is literally days after K-Swiss instituted layoffs in its salesforce.

3) Kind of ironic that US companies are laying off, while workers in Vietnam are striking because recent 14% wage hikes are not enough! So the people making the product are refusing to work, and the people designing and selling the product are being fired. That's matching up supply and demand the hard way. How can this be a positive trend??

4) SG&A trends for COLM have been trending up in recent quarters due to investments in new brand initiatives (see Exhibit below, courtest of FactSet). That's a solid move - especially given the fact that sales have been struggling to find a bottom. COLM is 2 quarters away from much easier year-year margin compares. With cost cuts hitting in full in the 3rd quarter, could this thing be setting itself up for a margin pop in 2H even without a rebound in sales? At 5x EBITDA and 12x EPS this probably matters...

Vietnam Strike = Bad Bad News

Here's a major call out for you. 5,000 workers at a Vietnam footwear manufacturing plant went on strike shortly AFTER getting a 14% wage increase (by 100,000 dong to 800,000) -- noting that it is not enough to offset inflationary pressures. With consumer prices in Vietnam up 21% versus last year, I can see the logic. Is it any coincidence that this happened simultaneously with a 325bp overnight hike in rates in Vietnam? Not a chance.

Vietnam might seem like a rounding error relative to China, but it is not. It's the number 3 producer of athletic footwear, and is a perennial top 10 apparel maker. Though share is only 5% compared to China's 85% in footwear and 40% in Apparel, Vietnam serves as an important buffer for the industry when Chinese prices go up. (Recall that the same dynamic holds true for India, and as I noted last week, price trends are decoupling from what we've seen historically vis/vis China).

The bottom line is that growth is slowing in Asia, at the same time costs are headed higher. This plays into our key theme in Apparel and Footwear that an 8-year margin bubble is bursting. The US retail industry has only seen the beginning of the pain that is to come...

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QSR Valuations - "Global This Time"

A quick look at how the global this time theme is manifested in stock prices of select restaurant companies. The chart below shows the divergence in EBITDA valuations between MCD, YUM CKR and JBX.

Research Edge observations:
All four companies are experiencing declining traffic and margins in their respective U.S. business.
JBX and CKR are California centric companies.
YUM and MCD have strong international operations.
YUM and MCD are returning significant amounts of cash to shareholders.

The premium valuation for YUM and MCD are due to the safety net that investors seek from the global this time theme.

See Keith McCullough macro portal for more on the global this time theme!

SBUX - Starbucks France

The Starbucks brand has tremendous opportunity overseas, but it will not come easy. Starbucks's JV partner is proof that there are a few bumps in the road. For the third time in four tears, Starbucks appointed a new managing director to run the operations. Starbucks, which opened its first outlet in France in 2004, only has 41 stores in the country. One of the issues the company faces is the French culture is not a to-go culture.

Reading the Starbucks blogs in France I found a post that sums it all up:

Let's compare a shot of espresso in France to one in a Starbucks:

In France: a piping-hot demitasse served in a small ceramic cup with a couple cubes of sugar, the rich aroma suffusing the atmosphere.
In Starbucks: 1.5 ounces of weak, rapidly cooling beverage in the bottom of a 12-ounce "Dixie cup", that both smells and tastes like cardboard.

KSWS: Beware the Shrinking Salesforce

Not a secret that the top line at K-Swiss has been under massive pressure. The 2 and 3-year trend line is just about as bad as I can find in retail. That said, the sales decline has been flattening out, and SG&A growth recently rolled over, which is a pretty attractive inflection point in the operating profit trajectory from my perspective.

My interest in this one was all but squashed today when my sources realized that KSWS has taken the knife to its salesforce, with some senior layoffs over the past 2 weeks. Could we see the SG&A trend continue to improve at face value? Perhaps. But it always gives me the creeps when cost saves come at the expense of a salesforce.

Note: Chart below shows the change in market share for K Swiss in its 2 largest categories; Tennis and Lifestyle. Not a pretty trend. Data compliments of NPD Fashionworld.

Hedgeye Statistics

The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

  • LONG SIGNALS 80.43%
  • SHORT SIGNALS 78.35%