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Do CEOs Even Know Real Margins?

I've commented recently how the real earnings power of several softline companies with international exposure has been masked by different levels of investment over the past several years. With a smooth 40% slide in the dollar over 5 years (most notably, the last 3), my strong feeling is that even the most sophisticated CEOs are underestimating the extent to which favorable FX trends have boosted both their margins and competitive positioning. The better teams have upped the investment ante in this context, while the weaker ones have let the benefit disproportionately flow throw to the margin line. The 3% rise in the Dollar vs the Euro over the past 6 weeks is still short of the point where we'd consider it a 'trend' vs. a 'trade' but mark my words - if the recent trade holds and the dollar strengthens, some companies will be in for a very rude awakening. Biggest losers - GES, WRC, SKX. Best positioned - LIZ, TBL, RL and to a lesser extent ZQK. Check out Exhibit 3 below. Consider the following...
  • European exposure is clearly something to consider given the hiatus we're seeing in the Euro's climb vs. the Dollar. But where I think it gets interesting is when we look at the change in Europe as a percent of total sales over the same time period we saw the massive 40% FX swing. On top of that, we can look at how the company's margin structure changed.
  • While some company-specific drivers need to be considered, it's impossible to ignore such a massive rise in European sales in tandem with incremental margin improvement at select companies. These include GES, WRC and SKX (they just happen to be my least favorite names now - for other reasons as well).
  • The best positioned companies (or the least poorly positioned) include those that have had an increase in Euro as a percent of total yet have still had margins down. These companies are not without some fleas, but the analysis shows how they have upped investment levels when faced with company-specific challenges or global growth opportunities. These include LIZ, RL, TBL and ZQK. With these companies, I think we're at a point where we will either 1) harvest investment spending, or 2) cut free up invested cash that is not yielding appropriate returns. In other words, margins should still go up regardless of which way the Euro goes.

I Guess? We Should Watch Sell-Thru

There's no disputing that the Guess brand is red hot. My cautious stance on this one has nothing to do with 'brand heat'. It has everything to do with my view that GES printed too much margin during the top of an extremely favorable sourcing and FX cycle.

That said, as with all brands, I keep a close eye on every little data point I find. The chart below caught my eye. The good news is that the year/year change in average selling price is up dramatically in Guess' US wholesale business. This has been the case since about mid-2007 based on my math. The more interesting point is that the yy change in sell-thru rate has been negative in 4 of the 5 past quarters to the tune of 25%.

Bulls will point out that there's a lot more to the GES story than US wholesale. At less than 25% of cash flow, they're right. But for a well-loved, high-multiple name that has been a HUGE play on the weakening dollar, these are data points I simply cannot gloss over.


Source: NPD Fashionworld and Research Edge, LLC

PNRA - Grass Roots Breakfast Sandwich Survey

We have done a proprietary grass roots survey on the state of the new Panera (PNRA) breakfast sandwiches. We surveyed over 30 stores in the following states - CT, ME, MA, NY, DE, SC, FL, GA, IA, IL, KY, TN, TX, CO and CA. The following conclusions can be made from the survey data:

(1) The stores generally indicate the new breakfast sandwiches are well received.

(2) In about half the calls, we were given a wide range on the number of sandwiches sold per week - 200 to 500 per week.

(3) On the margin, it appears that the new sandwiches are bringing in new people, but there is clearly people switching from the souffle.

If you would like to see the comments by region please call for the details.
  • She is noticing some new faces in the store asking for the grilled sandwich
    But everybody is trying , Old and New customers
    Customers ask for it even after 10:30 - They want it for lunch too
    The new ones are healthier
    They are very popular in the store right now
    She is positive about new people coming to the store looking for it
    The most popular is the one with sausage
    Much better than the souffle
    But basically the old customers who used to eat the souffle are now trying the sandwiches
    The one with bacon is the best seller
  • They sell about 300 of the grilled sandwiches per week
    They sell about 60 to 80 sandwiches per day
    People still like the souffle but they are more difficult to eat because you'll need utensils
    He said that they were selling 3 to 4 dozen a day.
    She thinks people are switching from the egg souffle for the grilled one
    She is new in the store, but she can say the new sandwiches are really popular - The staff eats it instead of the souffles
    They sell 300 of the grilled sandwiches per week vs. about 200 of the souffle per week
    He thinks everybody is switching because it's healthier and tastes better
    He is observing some new faces but nothing major
    The old customers are the ones changing to the new sandwiches
  • She mentioned that they were selling as well as the souffles . She said this without me asking.
    People are definitely trying the new ones
    They sell about 20 to 25 everyday
    After trying the grilled sandwich some people stay with it and some people go back to the souffle
    It's easier to eat the sandwich
    Everybody wants to try it because it's new
    It's the best thing ever , she said about the new sandwich
    She stills like the souffle
    They are selling about 15 per day (of the new one)
    They are selling basically to the same customers
  • She's not selling so much souffles anymore
    He can't talk to me right now because he's busy
    He also said they've been selling the grilled sandwiches for an year now - it's about even (they sell the same amount of sandwiches and souffles)
    Panera, CO - They don't carry the breakfast sandwiches. He said, we're supposed to be getting them in June/July
    He said, We sell about 50 a day, and about 70 on the weekends.
    They are selling 50 grilled sandwiches per day and they used to sell 60 or more of the souffles per day now they are selling less than 20
    The souffle has a lot of butter and eggs , it's not so healthy
    They sell 80 sandwiches per day and about 17 souffles
Comments that stand out:

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SONC - Comments from Piper Jaffray Conference

When SONC preannounced on May 9th and lowered 3Q08 sales and FY08 earnings expectations, the company stated that March same-store sales were significantly below its targeted 2%-4% range, turned positive again in April and continued to strengthen during early May. Today, the company said that May sales picked up and returned to the +2%-4% range.

Value vs. Margins - Earlier in 3Q08, SONC was heavily promoting its Happy Hour program in order to drive traffic. These increased transactions came at the cost of lower than average checks. In order to once again drive profitable transaction growth, the company began in May to promote its value message along with a product at a higher price point, such as a premium sandwich like the Island Fire Burger and a $0.99 shake.

Labor cost pressures. Sonic responded to last year's minimum wage increase by raising prices by 4%. Looking back, the company thinks that the magnitude of the price increase may have hurt transaction growth so the company will not use a blanket price increase this July to offset the minimum wage increase. Instead, Sonic will be more price-sensitive and focus its increases to specific trade areas.

The company also mentioned that its restaurant margins in the first half of the year improved primarily as a result of favorability on the labor line, which may have come at the expense of the customer experience. The company recognizes that this type of trade-off will hurt its brand so there could be more pressure on restaurant margins going forward as the company focuses more on providing better customer service and feels more pressure from the minimum wage increase relative to last year.

Franchisee development. Drive-thru openings are increasing this year, but management stated that it is seeing a slowdown in new store development (still highlighted a strong development pipeline). Franchisees are continuing to invest in the system, however, by putting more money into retrofits and rebuilds.


MCD Shares up Big Today - Trade or Trend?

Last Thursday, retailers, for the most part, reported better than expected May comparable sales and the Morgan Stanley Retail Index (MVR) was up 3.4%. The next day, however, the MVR, reversed these gains entirely and declined further, closing down 6.7%.

Right now, MCD is trading up 4.0% in response to its better than expected May same-store sales results. Once investors read beyond the headlines and realize that U.S. margins are declining as a result of increased discounting (please refer to my earlier post MCD's Top-Line Momentum Continues...Will Margins Follow?), MCD shares could follow this same downward trend.

MCD - MCD's Top-Line Momentum Continues...Will Margins Follow?

McDonald's global same-store sales were up 7.7% in May, reflecting strong results in each of its segments, primarily Europe and APMEA, up 9.6% and 9.7%, respectively. A calendar shift, which added an extra weekend to this year's May results relative to last year, benefited this 7.7% number by about 2% (this shift will reverse in June, negatively impacting results by the same magnitude). All in, this is still a great number.
  • U.S. - MCD's U.S. same-store sales were up 4.3%, which represents an uptick from recent trends (-0.8% in March and +2% in April). The 2-year trend increased to 5.9% in May from up 2.8% in April. Pricing in the U.S. has been running up about 3%-3.5% so the 4.3% number implies about a 1% increase in transaction counts, which is an improvement off of March and April's implied negative traffic results.
  • What is driving those transactions? The company stated on its 1Q08 conference call that although it is seeing more activity on the Dollar Menu that it remains consistent in the 13%-14% of sales range. Since then, an Ad Age article quoted Gregg Watson, VP of marketing at McDonald's USA , saying that Dollar-menu sales in the U.S. are now roughly 15% of sales, on the high end of the 13%-15% range that's been typical during the past 5 years... This increased range signals that these Dollar Menu transactions are becoming a bigger part of MCD's U.S. sales mix. NPD data points to a similar trend within the entire QSR segment, as the percent of transactions made on deal have grown from 21.5% in 3Q07 to nearly 23% in 1Q08.
  • MCD's higher U.S. same-store sales are translating into an increase in less profitable transactions. That being said, MCD's U.S. company restaurant margins have declined in the last 5 quarters with 1Q08 falling 20 bps on top of a 30 bp decline in 1Q07. Margins declines in light of sales growth typically highlights a real problem and this seems to be the trend at MCD's U.S. business, particularly if 2Q08 marks the first time these dollar-menu transaction move outside of the company's historical 13%-14% of sales range.

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