O'Charley's, LongHorn, SNS, RT - More Pain from Rising Gas Prices

Today's NY Times included the U.S. map pictured below, which highlights the parts of the country that are being hardest hit by rising gas prices relative to income levels. According to the map, people living in parts of Alabama, Georgia, Kentucky, Mississippi, Missouri, Montana, New Mexico, North Dakota, Oklahoma, South Dakota, West Virginia and Wyoming are spending the biggest percent of their incomes on filling up their gas tanks. This has to take a toll on discretionary spending, such as dining out!
  • Within the casual dining segment, the O'Charley's concept has about 37% of its store base exposed to these hardest hit states. Thirty percent of LongHorn Steakhouse's restaurants are located in these states while Steak n Shake and Ruby Tuesday both have about 20% exposure.

YUM - New Questions to ask Management about China!

Without the China engine the YUM story is less compelling. Whether it's a YUM analyst meeting, quarterly conference call or the CEO speaking on Jim Kramer's TV show (the stock is down 9.5% from the last appearance vs. the S&P 500 down 3.2%), all the company wants to talk about is China. The company recently hosted an analyst meeting in KY and they spent nearly 1/2 of a 1.5 day presentation talking about China. I question whether investors will be provided with this same level of disclosure now that the Chinese market is showing signs of stress? With all of the hype over China, it is easy to forget that nearly 50% of the company's operating profits come from the U.S.
  • Including yesterday's performance, the Chinese market has declined -52% from its October 2007 peak and inflation is accelerating. YUM's senior management expects that commodity inflation (including higher chicken costs) will continue into the first half of 2008 and moderate later in the year in Mainland China. It appears that the company's expectations will need to be adjusted in the coming months.
  • China is a black hole to most Americans and my guess is that most American companies don't properly risk adjust returns for the capital put into China - just ask Caterpillar Inc. (CAT). Today, CAT learned a big lesson about doing business in China! A story ran on the Dow Jones news wire that said the Xuzhou Construction Machinery Group is going to exit its JV with Caterpillar. President Wang Min is quoted as saying the company plans to sell its 15.87% stake in Caterpillar Xuzhou and set up its own excavation machinery unit. CAT is scrambling to try to figure out how to continue to cooperate with the Chinese company.
  • We bring this up because YUM's partners in China are essentially state-owned enterprises. Despite having a majority ownership position, YUM historically has not consolidated any entity in China, instead accounting for the unconsolidated affiliate using the equity method of accounting. More disclosure?

Casual Dining - Driving Traffic vs. Margins?

The NPD Group's data points to a sequential decline in 1Q08 in the percent of visits on deal within the casual dining group. Looking at recent casual dining trends through 1Q08, this decline in discounting typically bodes well for company EBIT margins. In 1Q08, an average 18.3% of visits were on deal, which despite the sequential decline from 4Q07 still represents an 80 bp year-over-year increase over 1Q07. April, however, posted both a year-over-year and sequential decline with the percent of visits on deal falling to 16.9% (down 60 bps and 20 bps, respectively).

Casual dining margins will continue to feel the pain of rising commodity costs and a weakened top-line, but driving transaction growth at the cost of margins is not sustainable. CAKE's CFO Michael Dixon recently highlighted this very point, saying We believe these types of promotions can have some short-term sale benefits, but usually at the expense of margins. More importantly, they can potentially have a long-term negative impact on a brand.


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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
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