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BBBY: One Word...'Solid'

One word: Solid


Ok, a few more words...


BBBY reported 1Q EPS of $0.34, substantially ahead of the Street which was looking for $0.25.  Our model was looking for $0.27.  The beat came on all three key line items.  First, same store sales came in at only down 1.6%, about 80 bps ahead of the Street.  We were looking for down 2%.  Gross margins were much better than expected, down only 44bps vs. our model which had them down 80bps.  Sequentially the performance was better than 4Q. This further indicates the real opportunity in the near term from the Linen's liquidation still lies with a more benign promotional environment and fewer coupons.  SG&A was much better as well, with the expense ratio down 163 bps.  We were modeling a slight decline.  Finally, the balance sheet was solid with inventories down just over 1%, against total sales that grew by 2.8%.  Still no debt and a growing cash balance now standing at $855 million.  With almost $900 million remaining in share repurchase authorization, perhaps we'll see some activity there as the cash generation accelerates.


Bottom line here is solid outperformance with all of the key metrics coming in better than expected.  I still believe there is more upside to come as the year progresses and the couponing subsides.  To report a down 1.6% comp in what most would consider a very tough environment for home-related products is a standout on its own.  EPS growth of 14% is also a rare commodity these days.


 Our thesis here remains unchanged.

  • Over the next 12-24 months BBBY is a "mean revision" story, driven by an improving economic backdrop, the elimination of the company's most direct competitor, and the bottoming of the worst period in modern history for home furnishings consumption.
  • Gross margin recovery is the most overlooked item by the Street and the source of upside over the near and intermediate term. A more rational promotional environment driven by Linen's absence is key to the story.
  • Modest square footage growth of 5% coupled with operating margin recovery should drive FCF growth in excess of 15% over the next 2 years. Cash flow yield remains attractive at 6.1% ('09) and 9.0% ('10) respectively.
  • Multiples are full, so this needs to be an earnings-driven story. The good news is that the Street's numbers are 1-year behind. $0.25-$0.30 beat per Yr1 and Yr2  x current multiple = $5-$6 in share price/yr.


Eric Levine



Export data released by the Japanese customs office today showed a decline of 40.9% year-over-year, lower than consensus estimates and a sequential decline from last month's figures.


Critically, May exports bound for China registered under 5% of Total exports -the lowest percentage in over 20 years. Although the Japanese auto manufacturers and other durable goods producers are participating in "the client's" recovery financially through joint ventures, the reliance on higher margin North American and European markets continues to keep domestic assembly lines stalled.

With job security still weighing heavily on domestic consumers and nowhere for rates to go but up, we continue to see Yen weakness as the sole near term positive catalyst for Japanese manufacturers as they grapple with stagnant customer markets.

Andrew Barber


Liquidity Abounds!

Today the ECB announced it will offer 442 Billion Euros of 12-month loans to banks at the current Euribor rate of 1.57%.

This is a massive issuance with a minimal rate of interest! In context it's equivalent to one third of all sovereign issuance in the Eurozone this year, and should go a long way to unlock European credit markets. Since October 2008 the ECB has lent to banks for terms of 6 months against eligible collateral; yet this new issuance is a sizable boost. 

Today was the first of three auctions scheduled for this year, with the others set for September and December. The increase in lending is bullish for European recovery, which the Central Bank has forecast to decline 4.6% this year before returning to mild growth next year. We'll be monitoring the extent to which these monies reach Main Street. Should mortgage rates compress it could significantly improve the consumer's health.  Despite increased business and consumer sentiment readings from Europe's largest economies (German, France, and Italy) retail sales and exports -as well as home prices and sales, are at depressed levels with little signs of sequential improvement across most of Europe. 

We've had a bearish bias on Europe generally but have strategically traded European countries from a fundamental and quantitative set-up this year as we anticipate greater divergence between the major EU economies as the global recovery process continues to drag on. We're currently short Italy via the etf iShares EWI and have recently traded the Swedish and German markets on the long side, and the Swiss market on the short side.

Matthew Hedrick

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While Jack-in-the-Box is outperforming some of its competition (Carl's Jr.) on a same-store sales basis, it's underperforming the industry-behemoth McDonald's.

Generally, I like the direction management is headed by concentrating on the core business by selling underperforming, low return assets. While it's not new news that JACK has agreed to sell 55 of its 61 Quick Stuff convenience stores and gas stations, it is a statement as to where management is taking the company. The re-franchising strategy is also a long-term net positive, but the dilutive nature of each transaction is less of a positive.

The biggest negative for JACK has been the rapid growth in capital spending over the past two years, which has contributed to the decline in JACK's return on incremental invesed capital (ROIIC). Over the past two years capital spending has grown 10% and 16% faster than revenues, respectively.


Management doubled its new Qdoba company-operated openings in 2008 just as same-store sales started to slow. The company plans to increase Qdoba company openings to 30-40 per year from its prior 10-15 run rate (21 in FY08 and 25 planned for FY09). In this environment, it's unlikely that the company will get paid for an accelerating rate of growth. With Chipotle growing at 125+ stores a year, the heat in on Qdoba not to fall too far behind, a situation that is not necessarily good for shareholders.

The company is increasing its Jack in the Box company openings in FY09 at the same time it is accelerating the refranchising program. Increasing company new unit development is clearly inconsistent with the company's refranchising goal of operating less company restaurants.
The company has attributed part of the increase in capital spending each year since at least FY06 to its ongoing reimage program at Jack in the Box so it is spending incrementally more on these reimages each year. In FY08, the capital spending increase was also attributed to a kitchen enhancement program at Jack in the Box (a program to increase restaurant capacity for new product introductions while reducing utility expense using energy-efficient equipment) and the purchase of smoothie equipment.

While these non customer-facing initiatives, such as the kitchen enhancement program and the purchase of smoothie equipment, are important, they do not typically generate incremental returns. Based on my estimates, with the number of new company units coming down in FY08, these non customer-facing initiatives grew as percent of overall capital spending at the same time capital spending grew 17% YOY, thereby explaining the decline in returns. The company plans to maintain the same level of capital spending over the balance of FY09 but with new company unit growth accelerating in FY09 relative to the prior year and the kitchen enhancement spending wrapped up in FY08, a greater level of the spending should be allocated to more customer-facing and typically higher return initiatives.

The real turnaround in returns could come in 2010. The company's exterior reimage program is expected to be complete by the end of fiscal 2009 and the interior reimage program finished by 2011 so the level of capital spending associated with these reimages should be less going forward. If the company keeps its new unit growth in check and more prudently manages its capital spending, cash flows can be redeployed to shareholders, thereby providing a positive catalyst for the stock.


Obama's Focus

We watched President Obama's press conference from yesterday and have spent the last 18 hours internalizing it.  There are a couple of key takeaways that are worth emphasizing that relate to a few Research Edge TAIL (up to three years) investment themes.

The first relates to healthcare.  Our Healthcare Sector Head Tom Tobin has been involved in grass root efforts to advise the Obama Administration on developing a palatable healthcare plan.  He's also written some very poignant notes on the topic, so we'd encourage you to chat with him.  In effect, healthcare reform is becoming a major political issue for President Obama. Our summary of President Obama's comments relating to healthcare from the press conference are outlined below:

"Complicated issue, very optimistic about progress.  Forming the plan will not add to the deficit, thereby burdening the taxpayer. We will find the money within the existing healthcare system. Want to reduce cost, "can't throw good money against bad habits." If you like your existing plan, you can keep it, but maybe you don't. We need to fix the system now, so it won't be broken for everyone. 1 of 5 dollars we spend will be on healthcare in next decade. Status quo unacceptable. Reform is a necessity."

President Obama is making it very clear that he will expend political capital to reform healthcare, or at least attempt to reform healthcare.  This is obviously very controversial, especially with independents who were the key factor in electing Obama.  We have seen Obama's approval rating nose dive over the last few weeks, which has a direct correlation with the hospital stocks and, of course, his ability to actually get meaningful legislation passed.

Our healthcare team put together the chart that is attached below, which compares President Obama's approval versus the hospital index.  In lockstep, the hospital index has declined with Obama's approval rating.  The biggest drain on earnings for hospital companies is bad debt, which should only accelerate in the coming quarters with the increase of unemployment, even if at a lesser rate.  Therefore, Obamacare would in theory benefit hospitals as the insured become a larger percentage of the populous, which should lead to a decline in bad debt.  The action in hospital stocks seems to be suggesting that the viability of the Obama's plan is very much in question.

The other obvious call out from President Obama's press conference is a real lack of the focus on foreign affairs.  As the Politico reported:

" A couple of surprising words were missing from President Obama's 55-minute news conference on Wednesday: "Iraq" - and "Afghanistan. Also MIA: "Korea," "Pakistan," "soldiers," "surge" and "war" - as well as the Army, Navy, Air Force and Marines. The omissions were partly a result of the short attention span of the press, which did not ask about those topics after the president did not mention them in his opening statement. But the silence on those subjects also provides a striking illustration of one of the singular differences between Obama and his predecessor."

We have been discussing this point repeatedly.  For better or worse, President Obama is much less focused on foreign affairs than his predecessor.  The TAIL risk here is that this public representation, i.e. not discussing foreign affairs, is a representation of a private allocation of time.  In a time, when foreign policy risk is becoming more and more serious in North Korea, Iran, and Pakistan, there is risk that a lack of focus by the administration will lead to an inadequate, or reactionary response.  While playing defense on a potential North Korean missile launch towards Hawaii is appropriate if the North Korean regime is not a serious risk, it does send a message to other enemies of the United States that could potentially embolden them, which is a TAIL risk we need to consider.

Daryl Jones

Managing Director

Obama's Focus - hosp


SONC's fiscal 3Q09 top-line numbers came in worse than expectations with system same-store sales down 5.4%. The company was lapping its first quarter of easy sales comparisons, and management set expectations high when it highlighted this fact during its second quarter conference call, saying, "As a reminder, as we move into the third and fourth quarters, our same-store sales comparisons at partner drive-ins will become increasingly easier." Unfortunately, these easy comparisons did not translate into improving same-store sale trends. Instead, comparable sales deteriorated further from 2Q09, down 7.7% at partner drive-ins and -4.9% at franchise drive-ins, and worsened as the quarter progressed with May sales coming in lighter than March and April.

Like last quarter, SONC's declining average check became increasingly problematic. Following the introduction of its Everyday Value Menu in late December, SONC's traffic trends have turned less negative at the expense of its average check, which fell 4.9% in 3Q09 following -3.4% and -1.9% in 2Q and 1Q, respectively.

SONC - A BALANCING ACT - SONC 3Q09 traffic and average check

SONC is not alone in this balancing act between traffic and check with some of its QSR peers choosing to chase traffic at the expense of check and margins (MCD) and others failing to drive traffic with their premium-priced brand strategies (CKR). SONC had allocated all of its advertising dollars to promoting its new value offerings from January to April, which curbed traffic losses, but with its average check declining further, the company reallocated some of its marketing dollars back to its premium offerings in May. And what happened? Traffic was softer in May. Management recognizes that it must work to fix its average check and has introduced initiatives to do so, primarily by trying to re-engage its customers with its higher priced combo meal offerings, but there is no easy fix, particularly in this environment. As management stated, "Value is the number one item driving traffic these days and we need to make sure that traffic is sustained."

SONC ‘s quick success in its ability to drive traffic with the Everyday Value Menu, which grew to 10% of sales within 3 months of its introduction, and the subsequent fall off in traffic in May as the company decreased its marketing spending around the value menu only increases my conviction that CKR will not work in this environment. The company will not be able to drive traffic with its premium menu items. When CKR reports its fiscal first quarter results after the close today, management will continue to maintain that it must protect its brand and will not succumb to selling "margin-eroding" products. We already know that sales trends worsened during the quarter, particularly at Carl's Jr., which were down 5.1%, and I don't see them improving under this current premium sales strategy.

Despite the continued top-line weakness and declining average check, SONC's fiscal 3Q09 margin performance did provide some good news during the quarter. Both restaurant level and operating income margins declined YOY but improved rather markedly on a sequential basis.


The company's refranchising efforts have seemed to help on this measure. In the third quarter, alone, SONC refranchised 177 units, bringing this year's total to 194 and lowering the company's partner ownership mix to 14% from closer to 20%. The positive impact from these refranchising efforts was felt rather immediately as underperforming partner drive-ins that were refranchised had less of an impact on margins and SG&A expenses came down as a percent of sales. As the company benefits from increased royalty revenues and focuses on fixing the fewer partner drive-ins in the system, margins should continue to improve going forward. In the near-term, however, there will some offsets to these margin improvements as the company is facing increased pressure on the labor line in 4Q09 with minimum wage rates set to increase yet again in July. Additionally, although management is expecting commodity costs to come down YOY in the fourth quarter, food costs as a percent of sales are expected to be flat to up as a result of the company's increased contribution from its value menu. SONC has done a good job of managing this food cost line following the introduction of its Everyday Value Menu but we knew it was only a matter of time before margins would take a hit from this new menu.



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