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Does a 20% Cost Increase For CROX Matter?

While most of the free world has never heard of the Rocky Mountain News, it has proven to be just about the most reliable general news organization on Crocs (through the Colorado angle). Earlier today, the RMN noted that Crocs is believed to rely on a DOW product that is about to implement a 20% price increase. While Crocs is very 'hush hush' about the secret formula for its Croslite material, the RMN noted that a patent issued in 2006 shows a polymer called Engage - sold by DOW - as a key ingredient.

Quite frankly, out of any footwear company in the industry, I'm least concerned about Crocs' cost pressures given that a stabilization of revenue will do more than any input cost increase. Also, I'm in the camp that the juice on the SG&A and capital intensity side of this model can more than offset any resin pressure.

No, I'm not making a bull call here. Not yet at least. But with the stock near $10 it's on my list.


SBUX - Comments from the Goldman Conference

Coffee war commentary continues - SBUX's CFO Peter Bocian cited the company's current market share: 13%-14% of the brewed coffee market and just north of 50% market share of espresso-based beverages consumed out of the home. When MCD introduced its premium roast coffee in 2006, it received a lot of media attention and SBUX was often named as the company which would be hurt the most from a competitive standpoint. Now, with MCD expanding its coffee lineup to include specialty coffees (espresso-based lattes and cappuccinos), the media is again calling SBUX out as the biggest potential loser. Even before hearing SBUX's respective market share numbers quantified today, I was skeptical that MCD's specialty coffee introduction would substantially impact SBUX's performance going forward. In 2006, MCD entered a market where the market leader had a 13%-14% share position. Today, MCD is trying to tackle a market where the market leader holds more than a 50% share position. I think the numbers speak for themselves, but I can't help adding that the McDonald's product offering is very different from what Starbuck's serves.

More U.S. store closures on the horizon? - Starbucks said back on January 7, 2008 that it would close a number of underperforming U.S. stores as part of its turnaround strategy. The company quantified that number on January 30, 2008, saying it would close around 100 underperforming stores. Today, the company gave its first hint that the 100 number could be going higher when the CFO said he has a watch list for potential stores that may be on the bubble to close. Closing additional stores (beyond the already stated 100 stores) will only accelerate the company's ability to improve store-level operations and U.S. operating margins and will, more immediately, benefit same-store sales.

MCD - Comment from the Goldman conference

To date, McDonald's senior management has not included premium drip in the calculation for generating $125,000 from the new beverage initiative.

Today, Don Thomson President of McDonald's US said As you have heard before, we estimate that the sales potential for the entire new beverage lineup, from premium drip, specialty coffee, smoothies, frappes, bottle beverages and optimized travel drinks, that total is about $125K per restaurant, as you have heard us say before again.

We have not confirmed this with the MCD yet, but Don's comment represents a shift in the outlook for the new beverage line up.

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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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