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SAFM – Comments as it relates to the Restaurant industry

The set up for SAFM looks to be very bullish for the next couple of years if all of the pieces of the puzzle fall into place.

(1)    The surge in corn prices in 2008 caused domestic chicken processors to cut back on production, reducing the supply of chickens

(2)    As we sit here today, feed costs look to be headed lower.  A bumper crop of corn could send it to $2.50.

(3)    Retail demand remains robust, but food service demand is challenged.

(4)    If food service demand picks up in 2010 and supplies are tight - chicken prices are headed higher. 

(5)    Higher chicken prices combined with favorable feed costs means better margins. 

(6)    In 2011, SAFM will be bringing on a new production facility, improving operational efficiencies.

Clearly, weather can ruin any good story, but the set up for SAFM looks to be positive for the foreseeable future.

Some comments from SAFM senior management as it relates to Restaurant investors:

FOOD SERVICE DEMAND – “We continue to believe we will not see a meaningful rebound in food service demand until well into calendar 2010 at the earliest, and then only if employment numbers begin to improve. Consumers need to get their jobs and confidence back before they're going to start eating out again.  Fewer chickens than normal will be needed this fall to meet demand, and fewer chickens will be available, but we won't know until we get there whether or not the industry has balanced supply with what we believe will be reduced demand.”

CHICKEN PRICES – “Overall market prices for our fresh chicken improved during the quarter, compared to last year's third quarter. But I continue to believe the improvement has more to do with production cuts than demand improvement.”

FOOD COSTS – ($2.50 Corn?) “We expect feed cost to remain below a year ago for the rest of this year. The USDA August crop report indicated there should be an adequate supply of corn next year, and that the record number of soybean acres should produce a harvest that should help prepare the soybean balance sheet.

However, while all indications are this year's corn and soybean crops will be adequate, and that significant progress should be made replenishing depleted soybean stocks, market volatility will continue as concerns grow for an early frost and yield issues.  This is particularly true for soybeans, as old crop supplies remain tight and the expected large crop is needed.”

CHICKEN SUPPLY – “The chicken markets are no easier to predict than the grain markets. While egg sets have remained below a year ago, and we are heading into the fall with fewer chickens on the market, we are also heading into the fall and the seasonal reduction in chicken demand with weak demand at most food service establishments.”


EYE ON HOUSING – CASE SHILLER

The S&P/Case-Shiller Home Price Indices are calculated monthly and published with a two month lag.  It was reported today that the Standard & Poor's/Case-Shiller's U.S. National Home Price Index rose nearly 3% in 2Q from 1Q.  In January we predicted that the housing market will improve in 2Q. It has.

 

Home prices are still down 15% year-over-year in June (better than the expected consensus decline of 16.4) and down 30% from the peak in the second quarter of 2006.  The housing market is bottoming, but there is clearly a long way to go to get back to the peak.

 

Last week, the NAR reported that existing home sales jumped 7.2% to an annual rate of 5.24 million homes, the highest since August 2007.  With the S&P/Case-Shiller housing numbers now showing sequential improvement for the last two months, we would expect the existing home sales numbers to continue to get better in the short run.  If house prices have stopped going down and the free money policies persist, it makes sense to think that consumers will have an increased propensity to buy new homes, helping to gradually push market prices for homes higher (with “dark pools” of inventory overhang waiting in the wings to keep a ceiling on any substantial rally) . 

 

As we head into 4Q09, however, we are likely to see the best data points in housing in the rear view mirror as a result of the following three points (reiterated from last week):

 

(1)    THE PEAK SEASON - For those consumers with “need based” moves, it’s August and the kids will be back in school soon, if they aren’t already.

 

(2)    INTEREST RATES - Interest rates are headed higher in Q4.  See Keith McCullough’s note on “Bernanke Pandering” and you will get the picture.

 

(3)    THE GOVERNMENT - The Government home buyer stimulant is going to end.  The deadline to close a home purchase is November 30, 2009. The process of buying a new home is not quick and easy - finding a home, lining up financing and getting inspections and closing, all takes time to accomplish.

 

Howard W. Penney

Managing Director

 

EYE ON HOUSING – CASE SHILLER - caseshiller


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Lower High: US Consumer Confidence

While it’s interesting to have confirmation that one of the most relevant Pain Trades that remains in the hedge fund community is “short the US Consumer”, it’s always interesting to consider the context of that interesting point.

 

In the 2 part chart below, Andrew Barber shines a light on where this morning’s better than expected US Consumer Confidence number fits. The top part of the chart focuses on the our intermediate term TREND line, whereas the bottom part of the chart broadens our perspective to the long term (back to 1979).

 

Understanding that, in the intermediate term (3 months or more), that some of the Q1 2009 confidence readings are some of the lowest on record is very important. That explains, partly at least, why the US Consumer Discretionary ETF (XLY) is the best performing sector in the SP500 today of the nine we have in our Sector Views. From a contrarian perspective, the Pain Trade on US Consumer shorts remains up as a result. It’s the highest short interest group in our SP500 Sector Studies. Being long of short interest continues to pay off.

 

In the long term however, this morning’s US Consumer confidence reading of 54.10 is a LOWER-HIGH (albeit barely) than those dead cat bounces we saw in both September of 2008 (61.4) and May of 2009 (54.8).

 

Interesting is as interesting does and, remember, tops are processes, not points.

KM

 

Keith R. McCullough
Chief Executive Officer

 

Lower High: US Consumer Confidence - Consumer Condidence 12

 


4Q COMMENTARY

BKC’s 4Q09 EPS of $0.43 (including a $0.07 benefit from a lower tax rate) beat the street’s $0.33 estimate.  I would say the biggest positive in the quarter was the 130 bp YOY improvement in U.S. and Canada company restaurant margins.  The biggest negative, though somewhat expected following TAST’s 2Q numbers, was the 4.5% decline in system same-store sales in the U.S. and Canada. 

 

Judging by the stock’s significant move higher today, investors seem comforted by the U.S. margin improvement and the fact that traffic trends in the U.S. have improved each month since May (but are still negative).  Traffic has been helped by the company’s shift in focus to include more value offerings, such as the $1 Whopper.  Even with traffic getting sequentially better in July (as stated by management), I would expect the overall comp number to continue to be weaker than MCD’s U.S. 2.6% same-store sales growth and Wendy’s estimated 2.0% growth.

 

4Q COMMENTARY - Big 3 SSS

 

Q4 Earnings Call Commentary


Current macro backdrop continues to adversely impact results:


-higher unemployment (July's unemployment rate in the U.S. 18 to 39-year-olds is now 12% and even more disconcerting is the 20% unemployment rate among ethnic groups in this age group which represents a disproportionate amount of the heavy user and super fan base)

-more consumers eating at home (out of home eating expenditures which are now at a 28 year low in the U.S. according to the NPD group)

 

Current comp trends (most of Q&A focused on U.S. traffic trends):


- U.S. comps and sales have improved since May although not to levels with which management is satisfied.  New value promotions will continue to put pressure on average check and it is expected to be flat to down.  Importantly, management stated that the dilution to gross profit margin, from these lower price points, has been lower than initially forecasted.

-Germany and Mexico comps and traffic have improved albeit still at negative levels.

 “I think the Mexican consumer is somewhat more confident…We have seen month over month continued improvement in our sales, and I don't think there is anything we need to do differently there.”

“In Germany I would say, again, a challenging economic environment there. We continue to move more towards affordability, and I would say there is more we can do on that front. I wouldn't say we're as far along as we are in Mexico. We certainly moved in that direction, but I think we can go further, and again I believe we have seen improvement over the last two or three months.”

 

Comments about Q1 Comp:


“I think we're not going to give you a number obviously on what we think from a comp standpoint for the quarter. You can tell from our comments we're saying the U.S. has gotten better month by month. We talked in our comments about the fact that Mexico and Germany had improved all be it we're still negative, so I think that gives you a sense of roughly how the quarter is looking, but that's all the color we really want to give at this point.”

 

Fiscal 2010 Outlook:


Management anticipates the current challenging environment will continue into fiscal 2010.  Due to the lack of visibility, the company is not providing specific EPS guidance for the year.

 

-most difficult to forecast is comps but expected to be soft in 1H10 and improve in the second half if consumer sentiment improves

-250 to 300 net new restaurants (represents a growth rate below long-term guidance due to commercial construction delays) with 80%-90% of net new units outside the U.S.

-U.S. commodities expected to be flat to slightly better (improve in the first half of the year and be up slightly YOY in 2H)

-Commodity costs outside the U.S. will be up a few percentage points YOY

-Capex of approximately $175-$200 million

 

Marketing:


After experiencing a rapid decline in traffic starting in March, BKC shifted its promotions to focus on satisfying the need for affordability with the $1 whopper junior in the U.S. and affordable combo promotions in Germany and Mexico and throughout many of the company's other international markets.

-also offering local market value promotions in the U.S., such as 2 for $3.50 Whopper® sandwiches and 2 for $3 chicken sandwiches, across many cities. Since implementing these value offerings, the company stated that it has seen a progressive improvement in traffic.

 

4Q09 commentary:


-U.S. and Canada Company Restaurant Margins: up 130 bps, benefited from 120 basis points improvement in food, paper and product costs, a 100 basis points improvement in occupancy and other operating costs primarily due to the lower accelerated depreciation expense related to the reimaging program incurred this year compared to last year and to a significant decrease in utility expenses partially offset by increases in labor costs.

-EPS increased 16% to $0.43 as compared to $0.37 in the same quarter last year. Currency translation negatively impacted earnings per share by $0.03 within the expected range for the quarter. This quarter's EPS was positively impacted by $0.07 due to a lower than forecasted tax rate of 21.6%, the result of the dissolution of in-active foreign entities. Without this tax benefit EPS would have been $0.36 for the quarter and within the company's previous guidance given in April.

 

 


CHINA: TACTICAL SHIFT

As we Follow tactical opportunities in the Chinese equity market, we have been tracking both the A shares listed domestically and H shares in Hong Kong separately in order to take maximum advantage of the divergent volatility in the two markets and share classes.

 

Currently the thirty day realized volatility for the Shanghai Composite is about 40 while the ten day realized volatility is about 54 versus 31 and 32 respectively for the Hang Seng.  Our preferred vehicle for A share exposure, CAF, has a thirty day realized volatility level exceeding FXI by 5 points despite the fact that CAF contains exposure to a larger group of individual equities, and exceeding the 30DV of EWH by almost 10 points.

 

CHINA: TACTICAL SHIFT - ssec1

 

CHINA: TACTICAL SHIFT - ssec2

 

From our perspective, this difference in volatility has created a more tolerable trading range for Hang Seng listings in the intermediate term that allows us a greater degree of tactical confidence selecting entry and exit points for now. We reserve the option to harness the greater volatility represented by the Shanghai A shares to our advantage however, in order to capture larger swings when compelling entry points present themselves.

 

One part of our thesis on this divergence of volatility is that, structurally, the closed Shanghai markets have become capable of greater volatility in recent month as an increasingly significant percentage of volume there has been driven by inexperienced investors including a large retail component (who are using margin for the first time since the practice was introduced late last year) and that the proprietary investing groups at domestic banks. These leveraged traders have been the catalyst for recent spikes in short term lending rates as the market has digested a heavy IPO calendar. Certainly there has been a significant “hot money” factor driving the Shanghai market in recent months.

 

The decision to choose exposure via an A share vehicle, H share vehicle or even through ADRs becomes increasing less important as the underlying investment duration is extended. In other words,  picking the right ETF or closed-end fund is critical for short term traders, but much less significant for longer term investors (provided that the divergence between the valuation metrics for each class are inside a band which is historically reasonable –valuation and not volatility becomes the compelling selection factor on a long tail basis). As we manage our portfolio tactically, in real time, we will continue to select our vehicles to maximize our performance to risk balance.

 

Andrew Barber

Director


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