KSWS: Warming to a Dog

Core biz hit bottom, new biz ramping while R&D rolling and product costs out of Asia are down. New CEO at FL is big call option. Until then, $11 stock with $5 is cash. Not bad when I’m modeling a 40% 2-yr growth acceleration and 25 point boost in mgns.


It’s pretty darn rare for me to warm up to a story when sales are down 35% and inventories are flat. That kind of trajectory and its implication for margins is just outright scary. But K Swiss is proving to be the exception. I think we’re at an inflection point here. It will initially be a ‘results are trending less bad’ story, but I have many reasons to believe that fundamentals will turn positive within 12 months.

Here’s the ‘Then vs. Now.’

Then… (2007-Today)

1)      K Swiss has had a fashion trend going against it for the past 2-3 years (weakness in ‘classics’), which hit revenue by 50%.  Some companies would retrench and pull back in every spending area imaginable when under such top line pressure. But KSWS invested in two new technologies – Tubes and miSoul in order to grow around the core fashion category.


2)      At the same time, we were looking at the tightest capacity strain out of Asia that we’ve seen in over 10 years. Not a pleasant margin event for anyone in this industry – especially a small player like KSWS.


3)      Foot Locker was a massive drain on KSWS’ top line. I’d characterize FL as one of the worst managed companies in retail over the past ten years – up there with Sears. As FL struggled with its US business, it cut KSWS orders meaningfully. FL went from a peak of 29% to less than 10% today. Being held hostage to a bad retailer is, well…bad.


4)      At the same time, the company was also dealing with its failed Royal Elastics division, which was losing money and distracting management.



Going Forward

1)      The new running line is ramping up at the same time the R&D related to the technology is rolling over. In addition, a new line is always lowest margin when it starts – i.e. now. Each incremental pair that sells gets more profitable due to amortization of tooling and molds.


2)      I feel pretty comfortable in banking on KSWS’ ‘classics’ business being close to the bottom. It’s now sub-$200mm globally. The math there on both door penetration and pair per door is pathetic.


3)      We don’t need to assume any growth in the core, and with the addition of running, Palladium (its new boot business) and skate, we’re looking at over 40% growth in revenue over 2-years.


4)      With costs out of China coming down near double digits for footwear as capacity reopens from 6,000 factories up to a number closer to 10,000 in the Pearl River Delta, there is a meaningful COGS tailwind.


5)      Let’s not forget the Foot Locker factor. Next week, the new CEO starts his job – Ken Hicks, formerly President and head merchant at JC Penney. Think about it…If you come from a company where you flat-out own every vendor that tries to sell to you, and you end up at a retailer where one brand is half of your sales (Nike), what will your first move be? Probably to sit down with smaller, but profitable, brands that can be better partners to Foot Locker under its new leadership. Keep in mind that a K Swiss classic shoe is one of the most profitable sales for FL. I don’t have anything in my model for a major change in this relationship.


6)      Did I mention that KSWS has over $5 in cash on its balance sheet? With the stock at $11, and near a buck in EPS power, this is tough to ignore.


What concerns me…

1)      Time… You could have made the ‘great balance sheet’ call in each of the past 3 years. You’d have gotten smoked. There’s nice support here, but it might take time to get paid.


2)      I can’t shake the possibility that this management team goes out and does a stupid deal to ‘get more connected with the youth consumer.’  C’mon guys… Fix your current business, pull the levers you can, and get on with it. You’ve proven that your deal prowess isn’t anything to write home about. In fact, you have yet to make one work.


3)      I want to make sure that these guys are allocating enough capital to growing these new businesses. If it turns out that I need to take up SG&A in my model north of 10% to get the product to resonate w consumers, then it’s tough to find any earnings.


KSWS: Warming to a Dog - KSWS miSOUL


KSWS: Warming to a Dog - KSWS Palladium 2


KSWS: Warming to a Dog - KSWS Tubes

Shanghai's SHIBOR Experiment...

Over 700,000 new trading accounts were opened by Chinese brokerage firms last week as more first time investors flock to the Shanghai market. Even after last night’s downturn as the market digested a slew of newly announced IPOs the Shanghai composite is still up 84% YTD.  


The “it’s a bubble” crowd are pointing out, correctly, that short term rates have been spiking as more hot money flows into the equity and futures markets (see the 7 day and 14 day SHIBOR chart below). Despite an 18 basis point pullback last night the one week swap rate is still up 32% from this time last month. Clearly the bearish thesis is based on a common sense perspective that often: unbridled optimism + easy credit + inexperienced investors = an overextended rally.


Shanghai's SHIBOR Experiment...  - barber123


The “it’s not a bubble (just yet)” crowd – which includes the strategists at most big banks,  are arguing that multiples, while expensive, are justified by ramping internal demand dynamics that presents the best long term growth prospects on earth. In other words, on a longer duration the exuberance is justified. Where these cats were 9 months ago on China (100% lower) is beyond us…


The PBOC quarterly monetary report released yesterday stated with usual opaqueness that policy tools would be used to achieve “appropriate” liquidity levels. Although I am not privy to any inside track at the PBOC, if I was going to speculate about exactly what “appropriate” means in this instance –I’d guess that it means that the desire to continue bring new issues to market will be offset by an equally stronger desire to avoid any market volatility that could cause consternation among the masses in advance of the celebration of the anniversary of the People’s Republic on October 1st. As such any tightening of credit will likely be executed in stages designed to provide a soft landing. 


China is a managed economy, not a free market, and order is prized above all else in Chinese society. Therefore it is only natural that the powers that be in Beijing will attempt to manage the equity market towards an orderly outcome in advance of the biggest public event since the Olympics.


How appropriate.


Andrew Barber



I could spend the next 500 words expanding on all of the details of the past quarter and rehashing the guidance, which was obviously a big disappointment, but I don’t see the point.  Right now, the only thing that matters is what senior management is going to do to stem the decline in same-store sales and take the Chili’s brand to a level that will put it significantly above the competition.

While the current promotion “3 courses, 2 people for $20” may have helped have helped stem the decline in same-store sales in July, it’s not a game changer for Chili’s.  The current Chili’s promotion is only slightly different from the current Applebee’s promotion of “2 entrée’s for $20.”  Management acknowledged that this current promotion is only a short-term fix to drive traffic in this extremely competitive environment.  To that end, management said it will be implementing a new initiative in late fiscal 1Q2010 that it said will drive long-term menu innovation.  The company did not provide any further details about this initiative.

So what is management thinking?  The Brinker management team needs to be thinking that it must elevate the Chili’s brand, so that the food it serves is substantially better than the competition.  In the Bar & Grill “sea of sameness,” it’s imperative that it makes substantial changes and does not just launch some run of the mill value promotion.  Chili’s needs to start taking significant market share from its competition while its competitors are on the ropes.  Many of Chili’s competitors in the Bar & Ggrill segment are either marginally profitable or are so significantly leveraged, they have limited ability to navigate the challenging environment. 

Chili’s needs to go for the jugular while it can! 

Earlier this year, I had the opportunity to work in a Chili’s, put on a Chef’s coat and “fire up” a Fajita.  Without going into details, what struck me was how complicated it was to execute the current menu.  If my memory serves me correctly, there are three different sizes of chicken breasts with six different marinades.  It is very easy to put the wrong size breast with a meal at the wrong price point, costing the store incremental profitability.      

So why do I bring this up?  The menu has begun to complicate Chili’s ability to execute effectively.  Chili’s needs to simplify its back of the house operations by reducing the menu to include only the core items that represent the bulk of the chain’s sales.  At the same time, it can increase the quality of the items left on the menu.  A menu that is simpler to execute will translate into better food delivered to the guest with fewer complaints, thereby allowing the concept to build increased customer loyalty.  Importantly, it will provide a better work environment for restaurant employees.

A strategy like this is not without risks, but it’s also not unprecedented in the restaurant industry and for consumer companies.  In the restaurant industry, McDonald’s did it a few years back and the old “Philip Morris” did it in 1994 when it was under attack from “discount” brands.  Also, if I’m not mistaken, Grand Metropolitan (the UK based beverage company) reduced its SKUs in the mid 1990’s before it was taken over.

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Monkey Time: SP500 Levels, Refreshed...

Can our monkey hold onto the high-wire of price momentum into and out of tomorrow? Here’s the SP500’s setup into the unemployment report:


1.       Immediate term TRADE resistance = 1,011

2.       Immediate term TRADE support = 990

3.       Watch out below line of support = 967


I say watch out below because I think a close below 990 takes the monkeys down to the floors of their cages. We’ve had 14 straight days of positive TRADE and TREND across all 9 sectors of our SP500 views – the only other clanging momentum rally of that duration in 2009 was the one that ended, abruptly, at the beginning of June.


If you really want to throw a monkey wrench at this, think about the implications of a fantastic unemployment report tomorrow… Yes, it may very well drive the US Dollar higher (like the jobless claims # did today). Dollar up, and momentum monkeys fall down – you’re seeing a sneak preview of that today.


A worse than expected unemployment report tomorrow would throw everyone for a loop if it equated to Dollar down and everything straight up. That’s when you’ll see that 1,011 print. That’s the line I’ll sell. I’m a better buyer here.



Keith R. McCullough
Chief Executive Officer


Monkey Time: SP500 Levels, Refreshed...  - spref



QSR - Big 3 Market Share Shifts

We learned today that Wendy’s company-operated July same-store sales improved sequentially to up 2.0% (up 3.4%, excluding the impact of 300 fewer restaurants serving breakfast compared to a year ago) from -1.2% in 2Q09 (up 0.6%, excluding the breakfast impact).  From the chart below, you can see that Wendy’s had been underperforming both MCD and BKC in the U.S. since about 2Q07.

 In the most recent quarters , Wendy’s has started to gain share from BKC as Wendy’s increased its value messaging at the same time BKC focused more heavily on its premium priced menu items.  MCD is scheduled to report its July comparable sales growth on Monday, but has said that it expects its U.S. segment to post a number that is similar to or better than June’s 1.8% result (see my post titled MCD – July Sales Preview for more details).  Assuming MCD reports about 2% same-store sales in the U.S., July will mark the first month since 1Q07 that Wendy’s matched MCD’s comparable sales growth level.  And, excluding the YOY breakfast impact, Wendy’s may have actually stolen market share from MCD in July.  

BKC does not report fiscal 4Q09 (calendar 2Q09) until August 25, but the chart below reflects my belief that BCK’s same-store sales growth continued to decline on a sequential basis in the quarter and in July.  BKC acknowledged that its focus on premium products has failed to drive traffic and has more recently increased its advertising around more value items, such as the $1 Whopper Junior.  TAST reported 2Q09 results earlier this week and its Burger King same-store sales growth (TAST is a franchisee of 314 U.S. Burger King restaurants) fell off a cliff during the quarter on a sequential basis, -4.7% versus +5.1% in 1Q09.  These less than favorable trends continued in July with comparable sales down about 5%.  Directionally, these TAST results do not bode well for BKC. 


QSR - Big 3 Market Share Shifts - big3


OEH reported inline revenues but missed street EBITDA expectations, although I can’t say that we are surprised.  It’s hard to remember last time OEH beat expectations.  In any event, the stock and its value is more about the option on the real estate and whether management will act in the interest of its shareholders to eventually monetize it.


OEH 2Q09 Earnings call:

  •  Another challenging quarter for the industry and OEH
  • A few odd things to mention
    • Swine Flu decimated their results in Mexico
    • Thailand social unrest also impacted them negatively
    • Hit by rapid collapse in Russia
    • The positive is that excluding these properties decline was only 18% (RevPAR – local dollars) and these properties will have a lot of upside (super easy comps going forward)
  • They believe that they are at a pivotal point in the cycle, and the team now needs to focus on the long term- think towards the future and not the present.  What steps they are taking?
    • Reducing cost base
    • Deleverage by selling non-core assets
    • Focus on positioning for RevPAR & EBITDA growth when the market begins to recover
  • Cost cutting started a year ago, and have realized a reduction of $20MM in fixed costs.  Diligence on costs will remain, but the benefit from cuts will dissipate going forward
  • Trends they are seeing
    • Reduced occupancy accounts for 2/3rds of RevPAR declines
    • Bookings are very last minute
    • At the beginning of the Q biz was down 30% and ended up only down 18%
    • For Q3: they are 29% below in bookings
    • Rate contracted significantly in Europe
    • Q3 is their strongest quarter
      • July saw RevPAR down 18%
      • UK is weaker than most of their markets – hitting their feeder markets in Portugal
      • US groups market is very weak
      • Italy is only 6% down but Europe is 22% - Russia
      • US – Charleston is down 28%, but other properties are doing better
  • Sale of assets
    • Lapa Palace
    • Progressing with sale of Windsor Court set to close in September
    • Bora Bora also marketing for sale
    • Have 95 of the 181 units at La Samanna which they plan to sell over the next 3 years
    • Sold 2 villas in Thailand for 1.7MM
  • Looking towards recovery… the key lies in their brand
  • Balance sheet:
    • Restricted cash was $13MM
    • Windsor court debt - $37MM (in discontinued ops) and proceeds on the sale should be more than sufficient to pay off the debt
    • 7x net debt to EBITDA
    • Current debt includes $16MM of the Australian debt that was refinanced in July
  • Net cash flow of $15MM, 3MM of maintenance Capex, $11MM spent on Porto Cupacoy
  • Sale of Lapa Palace - $19MM Euros + 10MM deferred Euros to be received in 2010
  • Tax charges included current charge of $5MM and deferred charge of $10MM
    • Full year tax charge of 14-16MM


  • What kind of forward booking window do they have? Cancellation rates?
    • Booking window is very short – so outlook is scary. Taking as much as 30% of revenue in for the month in the month – 2 years ago this was unheard of
      • Cipriani 4% booked in July for July 2 years ago, this year 30% (for example)
  • What % of their business came from finance/ Wall Street in the past?
    • Can’t really answer that- not really their market – very hard to quantify that
  • Mexico was impacted by Swine Flu, Grand Hotel Europe, any improvement in 3Q09?
    • Mexico – think it will recover by end of the year
    • Russia – seeing reservations from the domestic traveler are coming back a little bit. This property is really a “Russian” occupied property- should recover when the economy there recovers
  • Taxes – spread out balance equally btw 3 & 4Q
  • What’s going on with the legal case against them regarding their corporate structure?
    • Still proceeding – will have an update in the Q
  • Last minute bookings – are they coming in at much lower prices?
    • “Being more flexible on rate”
    •  accounts for 13% of the business now – put out special last minute offers
  • Long haul traveler is still traveling, but the “weekend getaway” trip is getting canned
    • So US travelers are still going to Italy, but canning the short Caribbean trip
    • Europeans acting the same
    • Basically that 3-4 day holidays has just gone away, suffering the most
      • La Residencia
      • La Cite
      • Reid’s
  • Debt covenants?
    • Do have tight headroom on some covenants
    • Got relief for 2 covenants
    • Only have 1 hotel with CMBS debt
    • Windsor court - only asset with “toxic” level of debt- but it’s being sold
    • Everywhere else they have lots of room on debt to “asset value”
    • Coverage ratios are fine given the drop off in rates
  • How are the rate trends looking/ compared to occupancy trends?
    • Rates are coming down as they try to incentivize people to stay last minute
    • Entry level rooms in the shoulder season – “hugely” flexible.  Less flexible in the high season on suites/etc
  • Not going public on all for sale properties… have identified 8 properties that they will look to sell over the next 2 years (sounds like Grand Hotel was on that list)
  • Library / 21 Club status
    • Pushed back the whole deal by 2 years, paid an extra 9MM deposit
    • Re-evaluating what they will do if anything there – they may just walk away from it – try to sell it and get a manage contract
  • Are there any assets that they will “give the keys” back to the bank on?
    • NO

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