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DKS: Drink Facts, Not Cool Aid

Apologies in advance if this sounds self-promotional (it's usually not my style) but I've been convinced for a while that the bullish consensus on Dick's is dead-wrong. The market drank the cool-aid and ignored the facts -- that unsustainable comp and margin drivers were masking one of the most aggressive rent structures in retail. It's unfortunate that the market does not care about these things until management says so.

Even with today's guide-down and subsequent downgrades, I don't think people really get the real story here. With the stock going from $27 last night to $20 pre-market, and now to $23, it's clear that the market is scratching its head and trying to make sense of what to do here. While every fundamental story has its price, there's still plenty of risk not priced in here.

It's IMPERATIVE to take a bigger picture view on this name. It is really a question of 'Then' versus 'Now.'

THEN: Over the last three years, Dick's has been blessed with the following.
1) A rock solid consumer.
2) The Under Armour comp cycle, which disproportionately helped DKS.
3) An easy competitive landscape - as Sports Authority was taken private by Leonard Green and subsequently closed stores. Also, other Sporting Goods retailers (like Hibbett) were behaving nicely as it relates to store expansion.
4) DKS took up its high-margin private label business from less than 10% to a low/mid teens rate today.
5) Major vendors like Nike, Adidas, Columbia, Champion and Russell funded DKS' margins through significant discounts and flat-out price rebates in order to hold off share loss to Under Armour. This was funded largely through lower sourcing costs due to cheaper Asian imports.

While the business was rocking and rolling, no one on Wall Street cared that Dick's has among the most aggressive rent structures in all of retail. In other words, it is moving into locations that its profitability cannot afford relative to Kohl's, Bed Bath & Beyond, and Best Buy (examples of companies with whom it competes for retail space). As such, Dick's needed to promise higher rents in the outer years or sign less favorable terms to secure the locations. The strength in the business more than offset these higher costs, so Wall Street did not know (or care) about the risk. The stock was subsequently revalued from 8x up to 16x EBITDA.

NOW:
1) The consumer took a 180 turn and is on very shaky ground.
2) The Under Armour comp cycle is done like dinner. Still a great brand, and still growing nicely. But the days of 75%+ growth at DKS are long over.
3) Competitors are actually adding stores again, and are starting to step on each others' footprint (Sports Authority in Florida, Academy in Texas, and everyone in California).
4) Private label is close to tapped out without sacrificing margin.
5) I'm convinced that vendor terms will be less accommodating than in prior years bc a) UA growth is slowing and the need for competitive response is not as great, and b) there's no way that vendors can be as generous when they are being faced with 8-10% increase in their cost of goods sold. Let's not forget that 'Dick's Sporting Goods' is largely an apparel and footwear retailer. It is absolutely not immune to higher product costs. Check out recent postings on the topic.

So now we're looking at a situation whereby all the factors that hid high occupancy escalators are ebbing, and the real risk to the P&L is being exposed. Yes, the stock is more fairly valued today than 24 hrs ago. But 9x EBITDA and 16x earnings relative to the rest of retail? I don't get it - especially when DKS is just starting what is likely to be at least a 12 month downward P&L trajectory.

SBUX - A Few Positive Data Points

Starbucks' announcement yesterday to acquire substantially all of the assets from Coffee Vision, Inc. and Coffee Vision Atlantic, Inc., its licensee in Quebec and Atlantic Canada and transition 40 licensed locations to company-operated locations fits into the company's plan to accelerate its international unit exposure. Along with the 40 stores, the company is gaining full development and operation rights for retail stores in these two provinces. Going forward, the company plans to open more stores internationally than in the U.S. (about 3,500 stores internationally versus less than 1,200 stores in the U.S. over the next three years). The company is guiding to $800 million in capital spending in FY09, which is line with what the company spent in the U.S. alone in FY07 (which was a huge problem from a ROIIC standpoint), so as more of the company's growth capital expenditures are allocated to its international business, we should see returns improve dramatically.

Also, insiders must see good value at these levels. I always view it as a positive when I see insiders buying stock because they are obviously closer to the story than I am. Yesterday, one of Starbucks' directors bought 2,300 shares at $17.26.

Boneparth Swapping JNY for KSS?

Tough to miss the form 4 out of Kohl's today noting that Peter Boneparth picked up 2,500 shares at $48 this week. My initial sense was that this was the token stock purchase to show support as a new Board member. After all, the net cost was $113k. That's a lot of dough to most of us little guys -- but keep in mind that Mr Boneparth was paid $16.7 million (per JNY's proxy) upon his termination from Jones Apparel Group in July 2007. By my math, we've seen a $1.9bn hit to shareholder value as the organization tried to patch itself up post his departure. That's $114 taken from shareholders' wallets for every dollar he made upon exit. I don't get it. Really, I don't.

What I do get is that Mr Boneparth is quite savvy. First a lawyer, then Private Equity investor, then apparel industry magnate. He's bought and sold stock well in the past.

Kohl's is two quarters from lapping tough sales compares and product misses, gross margin squeeze, and SG&A deleverage. Anyone reading my postings knows that I am an uber-bear on the supply chain squeeze coming down the pike. This should absolutely hurt KSS, but perhaps not til '09. Does he see something in the back half that we don't?

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EAT - Getting It Right!

I wanted to contrast the direction Brinker is headed with the comments we made about CKR, JBX and SONC.

Brinker's management team has placed a big focus on what's happening within the four walls of each restaurant. In support of that effort, EAT has significantly reduced the number of domestic company-owned restaurant openings. In fiscal 2008, EAT is expected to open around 70 company-owned restaurants and only 15 or less in 2009 and 2010. The slowing of pace of development is driven by the need to improve returns from new units. In FY09 total capital spending will be approximately 185 million, or approximately 5% of sales.

It should be noted that capital spending as a % of sales for CKE, JBX and SONC is approximately 10%.

How much do you want to bet that EAT outperforms those names over the next two years?

How sustainable is the business plan?

We are always trying to understand how sustainable any given business plan is.
  • Despite the maturity of the QSR category, capital spending as a percent of sales has been ticking up for three quick service restaurant companies. Given the overall macro environment for the industry, I do not believe that this is the right time to be accelerating growth. I watched this happen with the casual dining sector and we know how that played out - supply outpacing demand........
  • In this post, we are looking at CKR, JBX and SONC, specifically, and through calendar 2007, the trends don't look too alarming with both EBIT margins and capital spending as a percent of sales increasing steadily since 2004. The problem lies in the fact that EBIT margins (for JBX and SONC) are somewhat stable despite softening top-line results. For CKR, they need to reevaluate the whole business plan...
  • With stable margins, management can now justify the increased spending, because the returns appear to warrant such investment. However, as sales trends continue to weaken as a result of a tough environment (and increased value options) combined with our belief that higher commodity prices are not going away anytime soon, we expect to see increased pressure on EBIT margins - erasing the apparent returns of accelerating capital spending.

MCD/SBUX - I love the SBUX-MCD debate!

I love the SBUX-MCD debate, because we have come full circle. In 2003, the investment community was under the assumption that SBUX (and other upstarts at the time) had made the McDonald's brand irrelevant. The consensus was wrong then.... and the consensus thinks McDonald's is going to alter the Starbucks business model. ....the consensus will likely be wrong again. It's a good thing we have Deutsche Bank to help build the consensus.

The Market value of MCD would not be in excess of $60 billion if they did not know how to compete effectively. Collectively, Burger King, Wendy's, Carl's Jr. and Taco Bell are all good, strong brands in the QSR segment because they have had to compete against McDonald's. The fact that McDonald's is moving into the specialty coffee space is good for SBUX. It will force them to be a better competitor. SBUX is in a strong position today because make most of the specialty coffee competition is irrelevant. McDonald's 14,000 store distribution system is powerful network and should not be dismissed.

Recently, DB recently published a 27 page report on MCD entering the specialty coffee business and the potential impact on SBUX. This research note was so one sided (and biased it appears to be a complete suck-up to MCD) and appears to have been written in a vacuum, as there was no information about the growth in the specialty coffee category and there was no mention of the impact on other competitors. It's almost as if Dunkin Donuts is irrelevant to the debate. I guess they don't want to get Bain angry.....

Anyone with excel, word and some level of creativity can publish the McDonald's company line to justify a couple of ratings. While senior management at MCD is risking a lot on the beverage platform, I can't believe that a note this one-sided is a good thing, or even reality. Of the 27 pages in the DB report, not even one page was allocated to the risks nor addressed where his potential assumptions could be aggressive. Since I don't want to open excel right now, I'm going to let words put things into perspective. But..... Not my words. Words from McDonald's owner/operators who actually have to execute the business plan. The following are direct quotes from people much closer to the reality of the SBUX-MCD debate than any of us will be......

I think it will be a hard sell for the company once real numbers are offered for coffee after the initial rollout starts. With Jan Fields hitting the road this winter; the full court press has started..
Specialty coffee could be done for 1/3 the cost. The sales don't justify remodeling the whole store. Good item... just way too expensive to put in. And I have had it for several months and do better than average with my sales of it..
This coffee thing is a train wreck. I have never seen anything so expensive and unproven crammed down our throats with so little resistance. There isn't a Starbucks within 100 miles of my stores and the company contribution is a joke. I just don't understand this one!.
The coffee programs still a crap shoot. We need a -Newman-deal.-type plan to make it worthwhile. The Corporation is getting too greedy
Coffee is a concern to me. Upper management has its head in the sand one more time. They should start to worry about owner/operators a little more instead of Wall Street. Without owner/operators upper management loses their golden parachutes. A big joke once again. Everything always comes and goes in cycles. I believe we are entering our negative cycle one more time.
McDonald's has enjoyed great sales run for the past few years. All good things must come to an end and this is ready to happen. The company needs to look at how hard they have pushed most operators and move to plan .B. quickly. The specialty-beverage rollout (CBI) comes at a time when McDonald's operators are under increasing pressure from both rising food and labor costs. Add to that the requirements for more labor to run a store, operators are in trouble. If McDonald's wanted to help operators and operations, it would move now to find ways to cut labor in the stores. The rollout of CBI could not come at a worse time for most operators. Operators have no more money to invest in the business. Many are living day-to-day. This also comes at a time when banks are under heavy pressure from bad loans in the housing market. Things could come apart for
McDonald's. Operators have no cash and nowhere to get a loan. Add to that the increase of the federal minimum to $5.85 an hour and [my state's] (and other states) increase to $6.90 and above in .08. Operators are under unreal pressure and something has to give. The system will lose some operators and things get worse. In addition, the operators can not hit the menu board to recover some of their costs. The increase of prices forces customers to trade down to the Dollar Menu -- a big loss leader for operators - thus making the problem much worse. The cost of both chicken and dairy are up this year. Chicken is now more than beef? The cost per case for delivery is moving up very fast leaving no profit on the bottom line for operators. Add the profit-margin pressure operators are feeling from the Dollar Menu and many operators will be out of business. As commodity prices raise, margins thin and the Dollar Menu eats away profits, operators and McDonald's will have a very poor year. Operator margins are under pressure. There is no room for a mistake or capital investment. The overall outlook is not bright for McDonald's. This is not a doom-and-gloom prediction but what is really happening to most McDonald's operators. As the economy slows so will McDonald's
The Dollar Menu must change with the times. The new coffee items do not look like a home run for individual stores but looks real good for McDonald's. My regional manager warned me not to take on more debt because he/she doesn't think the specialty coffee program will work and it will not pay for itself. Of course he/she will force me to do it anyway but he/she doesn't think it will work. I'm sure he'd/she'd get fired if I used his/her name...
Price of gas is hurting the restaurants on travel routes to vacation areas. Increased costs of doing business in the east; utilities, taxes, labor and backdoor costs don't seem to factor into the cost of paying for CBB. Most of the sales and profits of CBB come from iced coffee sales and sweet tea, which we are already doing without spending construction costs. Not much profit on specialty coffee yet that is where the costs of CBB are. If you take out financing to pay for CBB you will have trouble paying it off with the profits from specialty coffee (lattes, cappuccinos, espresso). So factoring in the increased costs, and poor profit on specialty coffee it has a negative effect on cash flow. I am sure though when McDonald's presents the figures for CBB they will include the products were selling without CBB to make the picture of cash flow seem like a brilliant move. Corporate careers will be made on this move. Why can't we just advance their careers and leave us alone!
They are trying to scare us into CBB with chatter about Starbucks. We can coexist beside Starbucks just fine. We sell burgers, they sell coffee. Leave it alone...
Let's keep iced coffee and forget the specialty drinks...

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