SBUX Vs. MCD - I can't Let Go

If you have been following the commentary I have been writing on SBUX and MCD, it's clear that I am not aligned with consensus. At least from a sales and earnings standpoint, SBUX has been a dud and MCD has been explosive. I continue to believe that, despite the current trend in sales, SBUX is making the right decisions and we will see some positive data points by year end.

While MCD trends remain strong, signs of stress are creeping into the system. Importantly, the stress is not coming from difficult comparisons, but from stress being put on the franchise system that will impact sales trends in the coming months.
  • The biggest issues facing the MCD system stem from the Dollar menu and the aggressive move into beverages. I have written extensively about the Dollar menu and the problems with increasing traffic at the cost of margins. The move to broaden MCD's beverage platform is a completely separate subject, however, and the resulting issues will take time to manifest. In short, any beverage the company sells in a bottle or can in place of a fountain drink will carry a lower margin. Enough said!
  • Recently, McDonald's has seen its fair share of insider selling and apparently, institutional selling, too. We came across the two charts to the right on Over the past three quarters, there has been a clear trend among the investment community to sell McDonald's. In 4Q07, the last time the stock was in the high 50's, the net selling was the highest in four quarters.
  • In contrast to MCD, the trends at SBUX are completely reversed. In 1Q08, SBUX saw net buying from institutions for the first time in a year! The current owners of SBUX know the issues and understand that the brand and the company are on solid footing. All we need now is that first positive data point and the herd will follow.

$4.00 Gas Is Not Good!

Yesterday, consumer stocks rallied on better than expected retail sales. As I said yesterday - I don't believe it! In conjunction with those comments, I highlighted a consumer survey that pointed to a consumer that continues to struggle.

Today, we have yet another data point, courtesy of Mark Lapolla at, confirming that commodity inflation is draining the trends in the cash economy.

As Mark Lapolla points out, the move to $4.00 a gallon gas is now eating up 85% of every incremental retail dollar.

Eye on Commodities: Some Positive Moves for Coffee Houses

Coffee and dairy prices were the only commodities to post declines this week. Coffee was down 0.9%. Coffee prices are only down 1.2% year-to-date but have fallen nearly 19% from March peak levels. Milk prices were down 0.7% and cheese was down 6%, but both are still up year-to-date, +6.5% and +3%, respectively. The commentary coming out of the Indian Coffee Trade Association reflected hopes of higher production in 2008 and 2009 and a slowdown in exports. It is estimated that India's coffee production in the fiscal year ending September 2009 will rise 12% and global coffee production 9%. The Indian coffee crop is benefiting from a better growing season.
  • Along the Mississippi in Missouri and Illinois, the National Weather Service is predicting the worst flooding in 15 years. To date, flooding has destroyed nearly 20% of the Midwest's crops. Many farmers have commented that the current condition is 2x as bad as 1993. The flooding is hitting the corn crop hard, with some forecasters saying the crop will be down 10% this year. The biggest movers this week were once again corn (+10.2%), wheat (+8.3%) and soybeans (+5.8%). Corn prices are now up 56% year-to-date and up over 80% YOY.
  • The company most levered to declining milk and coffee prices is Starbucks.

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MCD - Banking Euros

Foreign currency has benefited MCD's consolidated and European operating income growth in the last 7 quarters (beginning in 3Q06). Its currency-neutral growth is still impressive, but investors may have become accustomed to this F/X cushion. Europe's contribution to MCD's consolidated operating income grew from 36% in 2006 to nearly 39% in 2007 (partly due to the strength of the Euro and British Pound). This has made Europe an increasingly important component of the company's overall operating income relative to the U.S.'s 51% contribution and is one of the factors which helped to drive momentum behind MCD's stock as investors bought into the it's global this time theme.

MCD Europe's accelerated F/X benefit started to hit the operating income line at a very welcomed time for the company as it helped to offset the restaurant margin declines in the U.S in each of the last 5 quarters. The spread between the company's reported operating income growth and currency-neutral growth widened dramatically in 4Q07 and 1Q08 as the Euro has strengthened further relative to the U.S. dollar. So the F/X comparisons will become more difficult going forward! And if the Fed raises rates anytime soon, the U.S. dollar should follow.

MCD does not provide specific EPS guidance but it does highlight some major earnings components. The company's 1Q08 earnings release stated:

A significant part of the Company's operating income is generated outside the U.S., and about 55% of its total debt is denominated in foreign currencies. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the Euro and the British Pound. If the Euro and the British Pound both move 10% in the same direction compared with 2007, the Company's annual net income per share would change by about 8 cents to 9 cents.

Recently, these currency moves have worked to MCD's favor, but as outlined by the company, a move in the opposite direction will impact earnings in a meaningful way.

Consumer Survey - June spending intentions are not looking good

The conclusions from the June BigResearch survey are inconsistent with today's retail sales data.
Bloomberg is reporting that retail sales in the U.S. rose twice as much as forecast in May as tax-rebate checks spurred Americans to shop at electronics and department stores, helping them cope with record gasoline prices.

I don't believe it, and have some data points refute today bullish retail sales figures.

Each month, BIGresearch's Consumer Intentions & Actions Survey monitors over 7,500 consumers providing unique insights & identifying opportunities in a highly fragmented and transitory marketplace. The following are some significant data points from the June survey which is not consistent with todays retails sales numbers.
  • EconomyAlthough 45.3% of Americans report that they've received their economic stimulus checks, it appears that this boost to wallets is failing to raise morale regarding our June, fewer than one in five (18.8%) indicate that they are confident/very confident in chances for a strong economy, lowering from May's record low of 19.5% and less than half of June 2007's 43.9%: And adding to retailer woes: most consumers are making a beeline for just the necessities when June, 53.8% indicate they are focused on needs over wants, rising three points from May (50.7%) and up almost 7 points from one year ago (47.0%). Economic stimulus checks were meant to jumpstart consumer spending, but it appears that consumers are stalling...of the almost half (45.3%) who've received their checks already, more than a quarter (26.9%) are saving them, 23.0% are paying down previous credit card debt, 16.3% are purchasing the necessities (i.e. groceries), 15.2% have put the checks toward gasoline expenditures, while 14.3% are paying down installment loans. Only about one in twenty are putting their checks toward vacation travel (5.9%), apparel (5.1%), or electronics (5.0%).
  • Personal/FinancialWith gas prices crossing into $4 territory, an increasing number of drivers are rolling back on discretionary spending...among the now 86.0% who have been impacted by rising pump prices (a new high), the majority (54.7%) indicates that they will be curbing their cars and driving less...44.8% are reducing dining out, while - with the summer vacation season upon us - 44.1% are scaling back their travel plans: Most drivers expect no relief from surging fuel costs...almost nine in ten (87.8%) expect gas prices to continue to climb through the July 4th holiday, one in ten (10.3%) feels they'll remain stable, while a minor few (1.9%) optimistically call for a price decrease. Consumers are bracing for an average expected pump price of $4.39/gal come Independence Day, which may be right on target, given their prediction for $3.97/gal on Dad's Day.
  • Future PurchasesPractical consumers, faced with rising gas and grocery prices, a crumbling housing market, increasing unemployment, forecast a continued dismal 90 day purchasing forecast, according to the BIGresearch Diffusion Index (those who say they'll spend less subtracted from those who will spend more). With most categories continuing to decline from May as well as June '07, it appears that retailers will ring up a less-than-stellar summer selling season: Six month purchase intentions for high-dollar durables aren't expected to provide retailers with revenue relief, either...compared to one year ago, fewer plan to spend on autos, computers, furniture, home appliances, housing, jewelry, major home improvements, stereo equipment, DVD/VCR, digital cameras, and vacation travel. The one anomaly continues to be TVs...9.2% intend to purchase, a slight uptick from 8.9% in June '07.

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...)

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