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DRI - EYE on Capital Allocation

From the very first conference call announcing his promotion to the post of CEO, Clarence Otis, wanted to make an acquisition. His rational has always been that DRI could add 2-3% points to the top line growth rate. Personally, I never thought he would pull the trigger. I always found that to be counter intuitive to the success the company was seeing. For the first part of this decade, DRI outperformed its competitors with significantly lower revenue growth. DRI's rational pace of new capital deployment was the best in the industry, which allowed the stock to significantly outperform it peers. The company's slower growth rate allowed the company to focus on the existing system, while returning significant amounts of cash to shareholders. In the past we have referred to this as sustainability and DRI was the best in the casual dining class.
  • To me, the Rare Hospitality transaction was a game changer. The acquisition gave Clarence his top line growth, but at the expense of capital allocation. This is not to say the Rare deal was bad or a mistake, it just changed how the company deploys its capital, and DRI's stock price has since reflected the fact that it was an expensive acquisition and a poor short-term (1-2 years) allocation of capital. Unfortunately, for DRI, since the acquisition, the world has changed and the U.S. has entered into a consumption recession. For DRI to capture faster revenue growth, it needs to increase its spending on growth capital expenditures. Relative to other alternatives, this has the lowest potential return. So, DRI is accelerating growth at a time when the industry is slowing. On top of that, one of the new growth vehicles is seeing slippage in same store sales and increased commodity costs. That being said, overall, DRI has maintained the best same-store sales trends in casual dining.
  • Needless to say, the best thing that could happen to DRI shareholders would be for the company to reallocate how it deploys its capital as a return to more rational capital allocation should again be reflected in DRI's stock price. DRI is one of the strongest companies in the casual dining space and has a rich history of making shareholders money. Clarence needs the RARE acquisition to work, and integrating the two cultures of the company is critical, especially the employees at LongHorn Steakhouse. I believe management will get there. Right now, there is a full court press on getting the integration right.
  • From a cost perspective, the company is about two quarters away from lapping the big disaster that caused a significant amount of pain for shareholders. So the two key things we are keeping our EYEs on are signs of improved capital deployment and how happy the employees of LongHorn are!


Here's a GES nugget. I'm going through all the recaps of same store sales trends. I love the Bloomberg interview with Marshall Cohen, NPD's retail guru. In talking about the standout brands and stocks that he likes, Cohen noted how much he likes Guess?. The comment sounded something like this... Foreigners are going to resort areas on vacation and are spending with 'reckless abandon' on high end product. They're turning them into 'shop-cations.' This is one of the main reasons why Marshall likes the stock.

First off, Mr. Cohen has no business making stock calls. He data is a very good concurrent indicator of business trends, and as such he's got some good insight into consumer spending patterns. But a trend guy making a stock call? Big no-no. (Full disclosure, Research Edge is one of NPD and Mr. Cohen's clients).

In a roundabout way, his comment about 'reckless shopcations' supports my bearish view on GES. As I noted yesterday, I think that GES underinvested at the top of its sales, growth, margin, and FX cycle, and therefore printed too much operating margin. No one knows, or cares, right now when business humming and the perceived returns are 40%+. But perception is far from reality in retail.

This actually smells a bit like the sentiment around Dick's Sporting Goods last year. The company could do no wrong, and no one cared about DKS' aggressive lease structure and deleverage risk. Two weeks ago DKS shareholders found out the hard way.

I think we'll see the same with GES.

YUM - Thailand Speaks

Yum's China Division includes mainland China, Thailand and KFC Taiwan. Yum Restaurants International (Thailand) Co., Ltd., or Yum! Thailand, owns, manages, and awards franchise licenses to the KFC and Pizza Hut quick-service restaurant chains in Thailand. Currently, there are 306 KFC stores in 56 provinces and 75 Pizza Hut stores in Bangkok and major provincial cities throughout the country.

The Bangkok Post reported that Yum Thailand has not yet raised prices in response to rising petrol prices. Sran Smutkochorn, Managing Director of Yum Thailand, said ''Our costs are rising due mainly to runaway oil prices and [costs of] other ingredients. It does not matter if you are in the United States or Thailand operators need to be very careful about raising prices, as consumers are suffering from significantly higher costs of living. However, Mr. Sran said, the company would consider adjusting KFC prices if oil prices go up to 50-60 baht per litre in the next few months. - The price is now 41.09 baht per litre.

In contrast to KFC, Pizza Hut has raised its prices by 2-3% since March, according to the article. Despite the political uncertainties and sluggish economy, Mr. Sran is maintaining 2008 sales growth of 15-20% (1H sales grew 15%.) In 1H08 KFC sales grew 16%, including a 7% increase in same-store sales rise. The article stated that delivery represents 11% of KFC sales, up 27% YoY. Interestingly, the significant growth in delivery can partially be explained by higher petrol prices. Delivery also carries a higher average check.

Research Edge - In the current environment, a strong marketing calendar and cost reduction initiatives is the best way to protect margins.

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TSN - Implication for the Restaurant industry

According to the CEO of Tyson (TSN), Richard L. Bond, it is cheaper for Americans to cook most food at home, but the cost of food at the supermarket is rising faster than menu prices at restaurants; 4% at restaurants and nearly 8% in the retail grocery channel. TSN has raised prices on some products, but not at the same rate of inputs costs, especially chicken prices. According to Mr. Bond, the lag of higher priced corn is just now hitting the products that TSN is introducing to the market place. Four of the largest QSR restaurant companies have introduced chicken sandwiches at breakfast.
  • Cutting production - TSN has taken three facilities out of operation decreasing its slaughter capacity by 8,000 a day.
  • Shrinking Herd - The chart to the right is a graphic picture of the heard size going back to 1988. As you can see the inventory of cows peaked in the mid-90s and we have seen a continuous decline since then. In 2008, the inventory will be down about 1% and down about the same amount in 2009.
  • Chicken and coffee are driving breakfast transactions.......


Is it me, or does it feel like every US apparel brand (some quite mediocre) woke up one morning in the first half of this year and realized that they need to invest capital in Ch-India? Liz Claiborne is reported to be in talks with Reliance Retail to introduce some of its brands in India. Warnaco is going that route as well. Ralph Lauren, VF Corp, Phillips-Van Heusen. All of them. China is getting more capital as well -- not a shocker. Even companies like Brown Shoe are going into China to tackle the mass market.

I'm never going to penalize any management team for investing in growth -- especially in a market (India) with nearly 3.5x the population as the US. But it strikes me as so ironic that the capital investment into Ch-India ticks up when the US market becomes meaningfully more challenged. Unfortunately, the US is more challenged, in part, because imported inflation combined with weak consumer spending is hurting margins. So companies pull back investing in this market at a time when they should probably step it up to take share (in my opinion). Instead, they lack foresight/conviction, and play defense looking towards other markets with seemingly better growth.

Maybe these companies are taking advantage of the fact that the dollar appreciated 10% vs. the rupee in four months. Perhaps. But it is still down 15% from the '04-'06 trend. Also, shouldn't we consider WHY the rupee (and other Asian currencies) are acting horribly? Unprecedented inflation (food and other), political jockeying to curb social unrest, and draconian measures to attempt (attempt is a key word) to prevent India (and half of non-Japan Asia) from slumping deeper still into a borderline stagflationary environment.

My Partner, Keith McCullough, articulates the broader implications far better than me. I encourage you to take 10 minutes and read through his work on the topic.

Ges What Made it to My Bear Screen?

I think the Guess? model is getting stretched and that the current margin trajectory is not sustainable.

Ok, first let me acknowledge the bull case. Yes, the brand is hot, the organic growth is good, and the diversity of both the customer mix and geographic base offers some nice safety. Also, returns are high, and management's track record is tough to argue with. I get all that. But I think people are ignoring the potential for this model to inflect across the board. Consider this...
  • 1) GES has been a remarkable turnaround story since 2003 under new leadership. But this also happened right alongside a 28% depreciation in the US$ vs the Euro. Something to consider given that nearly a third of sales and 40% of cash flow comes from Europe. Look back to when companies like Nike and Ralph Lauren managed through their first FX cycles as global companies. Not pretty at all. GES has never had to deal with an inflection in FX. The extent to which there is a reversal in currency scares the heck out of me here. Check out the chart to the right. Margins up by 17 points when the USD is off by 28%. Ouch!
  • 2) It's also important to at least acknowledge that the GES turnaround happened in an extremely 'easy money' period for the industry as the influx of sourcing savings for this industry was in its sweet spot. This trend injected 3-5 points of margin into this industry by my math. GES definitely saw some of that. 3) A low expense structure is becoming more apparent. With a sub-28% SG&A ratio, GES is about as low as any quality higher-end brand I've seen (RL is close to 40%) - particularly one with such high international exposure. There are many companies out there that grossly under invest in their content. I do not think that GES is one of them. But I do think that GES printed a disproportionate piece of its excess earnings at the top of the cycle rather than reinvest into the SG&A line in the model. There are a few companies I can point to that can pull back expenses to the extent that times get tough. I think that GES has already pulled the goalie.
  • 4) I've gotta say that the Sales/Inventory/Gross Margin triangulation mildly concerns me. Over the past 6 quarters, inventories have outgrown sales by an average of 5%, and yet gross margins have been UP. There are certainly examples of others where the disconnect is more severe, but some of the most violent price corrections in retail have come when companies shift out of quadrant 2 in the chart to the right into Q3 or Q4 (clear inventories by way of taking down margins). This is especially the case with higher-multiple retailers like GES. So what scares me about this? Sales are slowing on the margin, and at an unfavorable delta relative to inventories. In that context, Gross Margin trends have been fair at best - and this is at the same time industry tailwinds become headwinds, and SG&A is starting to de-lever - even with relative strength on the top line. With even a moderate incremental deceleration in top line trends from here, this model could churn out significantly lower EBIT growth numbers. I certainly wouldn't want to be long this stock if the dollar turns. Things could get real ugly real fast.

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