DRI - Cutting costs at the right time

DRI beat 3Q09 expectations and raised its full-year 2009 guidance based on slightly better than expected sales performance and significantly better cost management. At first glance, I was not surprised to see that DRI had beat street expectations as I continue to maintain that DRI, along with EAT, is well positioned to outperform as a result of its consistently superior same-store sales relative to the overall industry and strong balance sheet. I was somewhat surprised, however, to learn how DRI achieved its better than expected earnings.

As restaurant companies have become more focused on eliminating costs to offset the challenging sales environment, this type of cost cutting earnings beat has become more common. Yet, DRI is one of the few casual dining companies that has not scaled back on new unit growth. Instead, DRI’s FY09 capital expenditures are expected to total about $575 million, up 34% from FY08. This capital spending number includes about $80 million of costs related to the company’s new corporate headquarters, but even excluding these costs, capital spending is expected to increase 15% from 2008 levels.

Most other casual dining companies have been able to cut costs as a result of their having slowed down new development and capital spending, which enables them to cut back on resources and eliminate the inefficiencies associated with new unit growth. DRI, on the other hand, was able to achieve such substantial cost savings on top of its continued unit growth. The company stated that it was able to mitigate the impact of sales deleveraging on margins, primarily as a result of aggressive cost reductions, which lowered costs by $10 million in the quarter. Management said these savings were achieved earlier and were of greater magnitude than it initially expected. Acquisition synergies also helped to lower costs in the quarter. The company anticipates that annual acquisition synergies will level out at about $55 million with much of those savings already in place.

Relative to DRI’s prior FY09 guidance, the company is expecting better operating margin performance a result of improved leverage of its food and beverage, labor and restaurant expenses. And, this is based on only slightly better 2H09 same-store sales growth at Red Lobster, Olive Garden and LongHorn Steakhouse of -1.5% to -3% from its prior guidance of -2% to -4%. Although I was happy to see the company achieve these substantial cost savings in the quarter and improve its restaurant margins in 3Q09 by over 280 bps on a sequential basis from the second quarter, I am somewhat wary of the company’s ability to continue to deliver such incremental savings on a go forward basis as the company maintains its unit growth targets. DRI did slightly lower its FY10 new unit growth expectations to 53-65 from about 70 in FY09, but this is still significant growth in today’s environment. Despite my reservations around DRI’s ability to further materially reduce costs, I continue to believe that DRI will outperform its competitors, largely as a result of its nationally recognized brands.

There was some concern communicated on the earnings call about DRI’s declining gap to Knapp trends in 3Q to about 3% for its Red Lobster, Olive Garden and LongHorn Steakhouse concepts on a blended basis from 5% in 2Q. Such a decline signals that DRI is potentially losing share to its competitors, which is never a good thing. This 5% outperformance in 2Q, however, followed a 2.7% spread in 1Q so although there has been variability quarter to quarter, I think it is important to note DRI’s consistent outperformance, most notably at the Olive Garden.

Breaking The Buck's TREND (red line) at 85.26

down -3% at 84.33 last...

Bernanke Breaks The Buck!

Never mind the manic media headline of “NO CHANGE” … there’s a BIG one here.

Allegedly, “Heli-Ben” is going to purchase $300B of longer-term Treasuries, $750B of MBS, $100B of GSEs…

This, as one of my macro teachers (Tim Russert) would have said “is BIG!”…

Why is it BIG?
1. Buying Treasuries breaks the buck
2. Buying Treasuries breaks the buck
3. Breaking the Buck = Equities Breakout!

The US Dollar is getting smoked here. Bullish TREND line support of the USD is now under siege – that support line for the USD Index = 85.26; we’re trading 85.27 now! The dominant Macro inverse correlation for 2009 remains USD vs. SP500. There is NO upside resistance now in the SP500 up to the 812 line. Short Sellers, beware of the Shark Line; there’s a pile of downside SP500 support built up down on that line at 759.

Keith R. McCullough
CEO & Chief Investment Officer

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The death of Macau has been greatly exaggerated. Only the passage of time will solve the crazy credit comparisons (1H 2008) in the Rolling Chip business. However, the more profitable Mass Market segment has held up remarkably well despite the much discussed visa restrictions. The chart below details the YoY change in monthly mass market gaming revenues.

Not only has Mass Market visitation been more or less sustained, it appears to be accelerating over the past few weeks. The easy answer is the Chinese economy is doing fine, still growing, especially relative to the rest of the world, and the stock market is up 22% year to date. I love the capitalism delta. More importantly, we’ve received anecdotal evidence that the Central Government has relaxed the visa restrictions. Some are speculating that visas can be obtained in 15-30 days now. This is a pretty big positive for the Macau operators.

The momentum appears to be building. Beijing has a vested interest in providing a tailwind for the new Chief Executive. Mass Market visitation is potentially improving earlier than we thought. The Rolling Chip comparisons ease considerably in September.

It seems that most of the Macau properties have experienced positive visitation trends as of late which should show up in the March numbers. Two standouts have emerged: the Grand Lisboa owned by SJM and LVS’s Venetian Macau.

March should look better

NKE Pre-Q: The Phantom Pre-announcement

NKE preannounced already, but people just don’t know it. Whether it takes the shape of a miss or a big guide-down I do not know. That restructuring announcement was Nike’s ‘get out of jail free’ card.

If there’s one company where I overwhelmingly get barraged with requests about my expectations into the quarter, it is Nike. (Note, over half of those come from investors that are not clients, so they do not get any form of response). This quarter, more than any I’ve seen in a while, is unique for Nike in that I really don’t think that the fundamentals matter a whole heck of a lot. Consider this…

Nike has not missed in 23 quarters – soooo good at managing expectations. I’d argue that it is the organization and incentive structure that does a good job in managing Senior management’s expectations rather than Sr Mgmt sandbagging.

Nonetheless…Nike also gives no EPS guidance, but usually gives enough pieces of the puzzle when it has visibility on its numbers. Not this time. The standard deviation in Nike’s quarterly estimates has been heading steadily higher (perhaps explained by the mayhem on Wall Street, but Nike’s trend is far higher than other companies) and this q is no exception.

But what I am often asked is “will the company preannounce if it is meaningfully off of the Street?” I usually have one answer, which is “Absolutely not.” But this time I’ll give the following answer… “They already did!” Whether it takes the shape of a miss, or a guide down I do not know. But when Nike came out and announced its restructuring and 1,400 person headcount cut, that was the company’s way of telling the organization, its customers, and The Street, that things have taken a dramatic turn. Anticipation of this is what kept me on the other side of this fundamentally and Keith short the stock several times from $65 down to the low $40s.

But the factor here that people are not baking in to the model is that this event will serve as Nike’s ‘get out of jail free’ card. It’s gotten to a point where it no longer beats on top line, FX, and Gross Margin, but will be relying on SG&A, FX hedges and maybe a lower tax rate.

If you were a CFO, and the rate at which your regional CFOs are beating plan is slowing (and starting to miss), you’re hearing really weak anecdotes are flowing in from the channel -- including bankruptcies, the rate at which you are growing organically is about to slow, FX is no longer your friend (see below), earnings visibility is not what it once was, and together with your CEO and Board the company recently announced a restructuring…what would you do? Most people would ensure that they’re investing in all the right initiatives today, that accruals are clean and appropriate, and that expectations are reset by the time we ultimately head out of this Great Recession.

Make no mistake -- I think Nike is proactively handling this situation, which is part of what makes it great. But it still does not help earnings for investors with a short duration.

Shark Line, Refreshed (SP500 Levels)

I re-ran the math for 11AM EST and come out with a Shark Line that’s 3 points lower than last night’s close. The Shark Line moves down to 759 (dotted white line), and underneath that line there is a strong base of support building (665-734, the green shaded water)…

Let me be clear, I am not trying to get cute with this Jaws metaphor. I am trying to help you manage risk. The last +15% of a short squeeze reminds us all that risk isn’t just managed on the downside. Given that the one thing I heard most from clients used to be “I don’t Trade like you do”, with each passing day I seem to be earning some respect that trading is the most proactive form of risk management one can employ in a Bear Market.

Importantly, overhead resistance within this Bear Market is formidable up at the intermediate TREND line of 829. From an immediate term TRADE perspective however, I now see upside to 804, and it could happen in relatively short order. Continued Technology M&A is a pending catalyst, and we just learned with IBM/JAVA this morning that the bid you see in Tech is real. In an environment where cost of capital is moving higher, the best way for mature companies to grow is to buy someone.

If the SP500 breaks down and closes below the Shark Line (759), those buying/covering (like I have been all morning) will drown to that 665-734 buying range. Shark hunting is not for the faint of heart.

Keith R. McCullough
CEO & Chief Investment Officer

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