LIZ: The Reverse Commute

Our HQ is in New Haven, CT -- about 25 feet from Yale University. I love my commute, because while everyone is driving south towards NYC, I am driving twice as fast in the other direction. That's what Liz Claiborne's announcement this morning sounds like to me. Liz is decentralizing its global sourcing operations such that its 8 top brand heads have the flexibility to go direct to the factories of choice to strengthen relationships between design and manufacturing -- even if it means going around Liz's sourcing infrastructure and using more expensive buying agents. This comes at a time when other companies are channeling a greater proportion of production through vertically controlled sourcing platform. I'm not sure I love this move as I do my own reverse commute. But I'll take action over inaction in this space any day.

On one hand, I give credit to any brand that acts in a way that compresses the lead time to get design closer to the point of consumer purchase. LIZ is an extremely bureaucratic organization with layers of approvals needed to push product through the system. This change might have some positive flow through as it relates to product relevancy from a trend perspective as well as inventory carrying costs.

On the flip side, given the immense cost pressures emerging - which I think is a paradigm shift for the industry - I wonder why anyone would choose to give up any form of size/leverage over key suppliers. In putting the cost inputs back in the hand of the individual brands - and potentially adding a 3rd party sourcing agent, this does anything but de-risk the cost model.

So how does this change my view on LIZ? It really does not. As I mentioned on 5/13, Bill McComb has been reinvesting cost cuts back into the organization over the past year. As such, he's sitting there with the highest SG&A ratio in the industry by a long shot, and LIZ has instituted a cliff-vesting schedule to incentivize 2009 performance based on EPS and ROIC hurdles. With nearly 500,000 options struck in the high $30s, he has one of three choices in '09; 1) watch his investments pay off in greater revenue and EBIT, 2) watch his efforts fail and subsequently cut (and print) several hundred million in costs, or 3) fail across the board, and risk both his current employment and the company's structure as we know it today. For a stock that has stopped going down on bad news, I don't see how any of these options won't be a positive.

EYE on Commodities - Chicken Egg sets

I was amazed to see this weekend that Sanderson's Farm (SAFM) is up 47% YTD, outperforming the S&P 500 by 51%. SAFM is a fully-integrated poultry processing company facing lower margins due to significantly higher feed cost. Despite the strong stock performance, consensus estimates are for SAFM EPS to be down 43% in FY2008, but showing 100% growth in FY2009. So the stock performance must be telling us something!

As it relates to the restaurant industry, if SAFM's profitability is going to improve despite higher feed costs, they need to be seeing better pricing. Obviously, this is not good for anybody buying chicken.

I found about an interesting leading indicator of chicken prices - chicken egg sets. Chicken eggs are set roughly 10 weeks before being sent to slaughter, so this statistic is a good indicator of future chicken production levels. As you can see from the chart below, the 6 week moving average has fallen significantly below year ago levels for the first time in nearly two years.

If we take the trend in chicken in egg sets, along with Pilgrim's Pride Corp's (PPC - the largest U.S. chicken producer) announcement that it was closing a processing facility and some distribution centers, we have a more rational industry as the producers adjust to higher feed costs and an oversupply of chicken.

Naturally, this means that the restaurant industry will be seeing higher chicken prices in 2H08 and 2009. The chains that appear to have more exposure to chicken are BWLD, PFCB, CAKE and those that have chicken as a part of their name!

MCD - Where there is smoke there is fire!

Advertising Age is the latest publication to run an article on McDonald's and the issues surrounding the $ menu. To the articles credit, it contains incremental data points!

Issue #1 - Franchisees are pushing back.

According to the article, one Texas market franchisees voted down local funding to advertise the dollar menu in September. Going back to an early post on MCD, I pointed out that the company is very focused on transactions counts as a driver of same-store sales. Increased advertising on the dollar menu helps to support transactions but takes away the advertising of higher-margin items. In the current economic environment a value message is important, but as Ed Bailey (a McDonald's franchisee with 63 restaurants in the Dallas area) said "when you begin to advertise it and make it your marketing campaign, encouraging franchisees to do it because transactions are slipping and comp sales are slipping," he said. Mr. Bailey went on to say the chain is pushing to boost transactions and same-store sales, with little regard for franchisees' bottom lines.

Research Edge: I feel that management is walking a fine line between trying to manage Wall Street's expectations for same-store sales and franchisee profitability. In the end, the health and profitability of the franchisee system will always win.

Issue #2 - Increased sales of low margin items.
The Ad Age article quoted Greg Watson, VP-marketing at McDonald's USA, saying Dollar-menu sales in the U.S. are now roughly 15% of sales, on the high end of the 13%-to-15% range that's been typical during the past five years, but the these shifts are seasonal and do not reflect the economy. Mr. Bailey, however, said dollar-menu sales have absolutely increased with the downturn but couldn't quantify the shift.

Research Edge: As I said before, increased transaction counts and a lower average check is a recipe for disaster. Clearly, these issues are not going away and management stance on the issues appears unwavering. It's important to note, that the same time franchise profitability is under pressure, Oak Brook is rolling out the specialty coffee initiative. From what I have seen, this puts even more pressure on franchisee profitability. Something has to give!

The McDonald's U.S. system has a number of serious issues to deal with and so far shareholders have been immune from the issues.

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GIL: Stock Popped, but Model Has Not

GIL's stock has had a nice bounce since hitting its $23.75 low on the 5/2 preannouncement. Tough to explain away every tick, but one of the factors is likely the 6% drop in cotton prices and breaking through basic technical readings. Perhaps it gets a boost today with the positive mention in Barron's over the weekend. That's good, no doubt. But this story goes way beyond cotton folks. I'm extremely cautious on the fundamental model here. Here's why.

GIL Then . Gildan is coming off of a 7-year run where it radically altered its cost structure as it shifted production from North America to the Caribbean basin. Over that time period, GIL used its improved cost structure to double its share in the 'blanks' t-shirt business to 60%, grow share in fleece to 50%, and still have enough cost cuts left in the tank to improve reported Gross Margin rate from 25% to 33%. As always, I've gotta give credit where it is due. GIL has succeeded in offshoring where others have failed. But the rate of improvement is in its 9th inning. GIL has benefitted from 20%+ top line growth, 1 point/yr+ annual GM rate improvement, extraordinarily low levels of SG&A spend, and a tax rate close to zero. That equaled net income growing by 3x over 4 years. Not a bad story at all, and no surprise that GIL's cash flow multiple went from 10x to a peak of 26x (now down to a still lofty 16x).

GIL NOW : One of the nice things about GIL is that we have visibility on its new capacity, and can make assumptions about productivity and pricing to forecast revenue. Based on my math, I think that revenue growth in '09 and '10 will slow dramatically from the 30% rates we've seen recently. At the same time, I think that Gross Margins (which had been heading straight up) will reverse course due to cotton costs and a shift in mix to mass retailers. As a frame of reference, GIL needs to take up price by 1% to offset every $0.04/lb in cotton prices. At current prices, we're already looking at a 2% price increase needed in FY09. That's tough to bank on. Lastly, I think it is important to note that GIL has an SG&A ratio of only 12%, which is lower than just about any consumer goods company out there. Given that the retail-growth strategy requires SG&A spending to build the brands, I don't think that GIL can continue to spend at a rate less than half its competitors. The bottom line is that revenue is slowing, gross margins are peaking, and SG&A needs to head higher. This should take a 40%+ EPS growth rate towards something well below 20% (and perhaps even 10%) for '09 and '10.

In the Barron's article, Royce Associates notes that Gildan could be double its current size in five years. That's entirely possible. But I'd argue that it would be at a margin structure about 1/3 below where it is today, and not worthy of its current mid-teens p/e and EBITDA multiple.

Chart below shows sales slowing, GM eroding, and SG&A heading higher based on my model.

Warnaco's Time Has Come

One company that has been on my short watch list for the better part of a year is Warnaco. I'm not the only one with that idea, as it has been a somewhat crowded sandbox. Much to short-sellers' dismay (and mine) this stock has done nothing but go up. But insiders are selling, inventory/sales spread is peaking, margin compares are getting tough, cotton costs are rising, and a cleaner P&L is making it tougher for WRC to sandbag. Not good.
  • Yes, the company has made some very good decisions over the past few years. No argument there. WRC cleaned its books after accounting irregularities (which were set in place in part by the ops folks under the former regime), as well as sold and closed down unprofitable divisions. There's no denying that this is a better company today than 2 years ago.
  • Now we're looking at a streamlined WRC, whose main profit engine is Calvin Klein Underwear. A great global business - and probably the best undergarment brand aside from Victoria's Secret. But with margins topping 20%, cotton costs up 30% vs. last year, and what I would argue is too much FX benefit flowing through to the EBIT margin line instead of being reinvested in the business (CKU as well as CK Jeans), this thing just smells off to me.
  • In addition, a key factor I like to track is the ratio of sales growth vs. inventory growth, and WRC's ratio has been defying gravity - leading the industry for 3 quarters. In fact, WRC's inventories have trended from 130 days to 110, partially due to divestitures. Though now inventories have ticked up, suggesting that perhaps they've found a near term bottom. When I layer that on top of WRC hitting very tough margin compares 2 quarters out, and a much cleaner P&L (making it difficult to sandbag with guidance) then I truly wonder how this multiple stays at a 20% premium to higher quality companies.

Market Share Blowout

I commented last week about my 'Athletic Footwear Rebound' theme, and FL being the best and most levered value-play on this trend. It probably makes sense to look at market share trends with the different brands as well. The trends are very telling.

Nike and Brand Jordan. What's there to say here? Business is solid. The brands have collectively gained 5 points of share thus far year-to-date (and not slowing). They won't give it up anytime soon. I wish I could say this about Nike's apparel business, which still can't find its groove. But with 46% share of a $9bn wholesale footwear market, Nike needs about 1.5 points of share gain to maintain the 3-4% top line growth rate necessary to fuel its broader financial model. 5 points gets Nike's USA team a strong finish to a solid year.

AdiBok: Adidas and Reebok can't get out of their own way. Brand adidas is not doing badly - market share consistently down by half a point (but getting less bad on the margin), and order levels are healthy. Adi might fare well in an athletic rebound as the brand never lost relevance (especially in apparel). But Reebok's chart almost suggests that share is going to zero. Almost every retail contact I have in my arsenal agrees that there is absolutely no reason to buy Reebok. The consumer simply does not want it. Reebok's share is down to 3-4%, but keep in mind that its share in lower-end department stores is closer to 8%. Yes, this is very very bad. With cost pressures heating up, and Under Armour coming in (Reebok owns the NFL license, and UA is all over football) my bet is that RBK loses another point at a minimum over a year. That might not sound like much, but it cuts the size of the US business by another 25%, or $90mm wholesale. While not a death sentence for AdiBok, UA has got to have its eye on this one.

One statistic I've got to throw out there is that New Balance - which has 9% of the US market - is larger than both Reebok and adidas combined. It now stands as the number 2 brand in the US measures in sales. Though with 80% of its sales in running and cross training (the two categories UA is targeting) I suspect that things will get ugly for NB.

Chart below shows year/year point change in market share by brand. Courtesy of NPD Fashionworld.

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