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CRI: Un-Pulling The Goalie?

Excuse me for sounding self-promotional, but I called this sucker a year ago. Carter's management has been self-inflecting deep paper cuts over the past 4 years, and is officially at the point where the company needs a transfusion. Current CEO Fred Rowan is 'retiring' and the company is passing over reigning resident Joe Pacifico for the top job. CFO Mike Casey is getting the nod - which is the best decision I've seen from this Board since just about ever. Consider the following...

Pre 2003: Carters is the dominant brand in the babywear market, with about a 35% share in this space. One of the most defendable brands in apparel retail. The product is very basic, has virtually no fashion risk and is more like a consumer packaged goods model than an apparel model.
2003-'05: CRI steps up its Playwear, Company Retail and mass market (WMT, TGT) businesses. Fashion risk enters the equation. Starts to compete with the likes of Old Navy. Initially does not feel the brunt of competitive pressure as sourcing savings more than offset unit margin pressure.
2005: Buys Osh Kosh, a family-owned brand with even greater fashion risk than Carter's Playwear.

So by 2006/7, CRI's business model shifted to a mix where less than half of sales comes from that core 'packaged goods' business and the rest is fashion. Not high fashion, obviously, but one where the competitive set is far more complex than CRI had when it sold mostly onesies and baby blankets.

CRI's response? It was to cut costs, of course. I love this example... Osh Kosh had about 500 employees when CRI purchased it in 2005, and now that employee count is closer to 150. A simple fact in this business is that brands don't sell themselves. It takes talent. Designers, merchandisers, marketing, etc... CRI aggressively cut costs from its model in order to buoy earnings. CRI did not appreciate this.

Think about it like this - how could a company consistently miss sales targets across virtually all of its fashion-driven businesses, subsequently face a 1,500bp slowdown in sales growth, and only see EBIT margins slip from 12% to 10%? It's what I call 'pulling the goalie.' Mask underlying weakness by cutting costs for a last shot at winning the game. As far as I'm concerned, the first team lost the game. The coaching staff was turned upside down, and now some tough choices need to be made before starting the clock and facing a new opponent.

What next? I still think a 10% margin rate is too high. Mr. Casey needs to buy himself some ammo. There's nothing stopping him from clearing the deck and resetting the margin bar at 6-8%, which is a level my math suggests would give him the resources to head closer to a profitable growth trajectory. That would take EPS from $1.40 to somewhere between $0.75 and $1.00, and is when the name gets more interesting to me. I think it's more likely than not that we see it.


(The chart below shows the disconnect between such a lack of EBIT margin change in the face of such severe business pressure. This is not sustainable...)

Restaurant Industry - 2nd Round of Minimum Wage Increases Coming Soon!

2nd Round of Minimum Wage Increases Coming Soon!

The Associated Press reported that effective July 24, the federal minimum wage will increase $0.70 to $6.55 per hour. This is by no means new news, but these higher labor costs will again be top of mind for investors as this second increase will impact most restaurant companies in the upcoming quarter (3Q08), putting even more pressure on margins.

SBUX - Better Capital Allocation Decisions

Starbucks shareholders have been penalized over the past two years for aggressive capital allocation decisions that have not generated the appropriate level of return. I believe management has seen the light and is now on the road of smarter capital allocation decisions which will reward shareholders.

A perfect example of a smarter capital allocation decision is the company's recent announcement outlining its new licensing agreement with SSP. Starbucks Coffee Company and SSP announced a significant licensing partnership to open more than 150 Starbucks stores in key European markets over the next three years.

The pan-European agreement gives SSP licensing rights to the Starbucks brand in travel channels, including airport and railway locations, throughout a number of significant markets and exclusive rights in France, Germany and the United Kingdom.

For Starbucks, this is the third announcement (following its agreement to acquire assets, including development and operating rights in Canada and its first store opening in Argentina) that signifies a change in the company's business model, particularly around its international operations. Importantly, the SSP agreement accelerates growth using a high margin, high return licensing strategy.

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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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