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SKX: Breakout Considerations

In what appears to be one of ICR’s big news names today there is actually little by way of change to note here. Taking into account yesterday’s head fake, the stock is up a more pedestrian 5% prior to Tuesday’s preannouncement. That’s not to diminish the 30%+ top-line growth management announced for Q4, but it is worth noting.  


As I sit here in the presentation, here are a few highlights from the earlier breakout:

  • DC transition progressing - with the company expecting to break ground in March, the timing of the transition in 2H of F10 or 1Q of F11 unchanged
  • Backlogs remain strong with men’s up vs. ’08, but still below ’07 levels
  • Men’s Shape-Up sales beginning to take hold now roughly 15%-20% of women’s domestic sales
  • Expect to see low single-digit increase in G&A in F10 (most leverageable line in the model)
  • Shape-Ups hasn’t necessarily resulted in new channels of distribution or retail relationships, but it’s enabling SKX to gain significant penetration in key players (i.e. Foot Locker, FINL, DKS, TSA, etc.)
  • When asked if we’re going to see them during the Super Bowl, I got a smile - not a definitive ‘no,’ but my sense is the company is happy with their exposure during the College Bowls over the last few weeks


If Kentucky Grilled Chicken was helping to drive increased traffic and profitability for its franchise operators, I think they would be in full support of the product.


It was reported earlier this week that KFC franchisees have initiated court proceedings against YUM over a debate as to the current direction of the company’s marketing campaigns.  According to a Washington Post article published on January 9th, a coalition of franchisees is not happy with the company’s focus on the new grilled chicken platform and decision to devote the advertising budget to promoting Kentucky Grilled Chicken.


YUM rolled out its Kentucky Grilled Chicken product nationally in 2Q09, supported by advertisements that told consumers to “Unthink KFC.”  When YUM reported positive 2Q09 same-store sales growth for KFC, it seemed that the company had finally found a way to drive traffic back into KFC.  That positive growth, however, quickly turned negative during 3Q09 when KFC’s comparable sales declined 2% (And, KFC was lapping an easy comparison of -4% from 3Q08).  The initial success of Kentucky Grilled Chicken was actually even more short-lived than that with management citing an “unprecedented” 30-point swing in same-store sales growth at KFC during the first month of the launch versus pre-launch, followed by a flattening of sales immediately after the introductory launch.  YUM’s 4Q09 same-store sales in the U.S. continued to be weak with management guiding to -8% in early December.


I don’t know how many of the 4,000-plus U.S. franchised KFC units are included in the coalition that is taking legal action YUM, but this type of “noise” in the system is never good for business and does not convince me that the grilled chicken product is yet as successful as management has claimed.  On the 3Q09 earnings call, YUM management stated, “At KFC, Kentucky Grilled Chicken has been an unqualified success.”  If this statement was entirely true and the grilled product was helping to drive increased traffic and profitability for its franchise operators, I think they would be in full support of the product and the advertising spending being used to increase trial of the product. 


During the company’s 2Q09 earnings call (the first quarter of the new launch), management stated in regard to Kentucky Grilled Chicken, “another reason why it’s very popular, not only with our customers but with our franchisees is the margins are actually better on a grilled piece of chicken versus a fried piece of chicken.” As I stated before, during 2Q09, the grilled chicken launch helped to drive positive comparable sales growth so franchisees may have been happy with the product, but at this point, the franchise community does not seem to be in complete agreement with the company about the push behind grilled chicken. 


KFC’s sales have been weak for some time now so management had to do something to try to turn around the brand.  Broadening the menu seemed like a good idea to me, but I do think it is always somewhat risky for a concept to pursue a strategy that moves away from its core competencies and its core users.  Yes, chicken is KFC’s core product, but that chicken has always been fried in the past and when people think KFC, they still think fried chicken.  It will take a while to train consumers to think anything else, which explains why the company needs to spend behind the grilled chicken platform.  In the meantime, the company needs to be careful not to abandon its core users who continue to want fried chicken.  Even if the Kentucky Grilled Chicken launch has driven grilled chicken to become an impressive 30% of KFC’s sales mix, fried chicken still represents a bigger piece of sales.  And, the company’s campaign to “Unthink KFC” may not appeal to the concept’s current users who were perfectly happy with the brand.



We were bullish on China for all of 2009 (outside of our call in July for a slight correction); we are not short China right now but we are not long it either.   


One of our more important themes for 1Q10 and potentially for the whole year will be our call on China.  We think there are a number of factors that are going to cause the growth machine to slow in the first half of 2010, thereby causing the market to underperform in the intermediate term. 


Importantly, the long-term TAIL story for China is still very strong.   


One way to think about China in 2010 is in terms of QUALITY GROWTH versus SPECULATIVE GROWTH.  From the recent actions of certain Chinese officials it’s clear that they don’t like the US and blame us for the financial crisis.  How ironic is it that they borrowed a page from the playbook that brought on the financial crisis.  The Chinese have flooded the system with so much money in a short period of time that the pace of growth cannot be maintained.  I don’t want to call it a bubble, but structural bubbles (in money supply and housing) are a threat to China’s growth rate, on the margin. 


The financial crisis put pressure on the Chinese government to stimulate an economy that was humming along at a very strong pace.  The Chinese economy has long been viewed as export dependent.  While exports are important for the Chinese economy the industrials side of the economy is now far more important.  It’s amazing to think that the Chinese economy barely missed a beat as the economies of China’s largest export markets - U.S., Europe, and Japan - were falling off a cliff.


(1)    Money supply growth slowing.  Right now the central bank has not stated a 2010 target for growth in M2, but had a 17% goal last year.   The actual growth rate was more than 25% for 2009, peaking at 29.7% growth YOY in November.  We think that money supply growth could be cut by 1/3 of its current pace.


(2)    Loan growth slowing in 2010. Chinese banks extended 9.21 trillion Yuan of loans in the first 11 months of 2009, compared with 4.15 trillion Yuan in 2008. We think loan growth could drop by at least 1/3 of its current pace.


(3)    Bullish on the Chinese currency. The Chinese Yuan appreciated +18.7% between 2005 and 2008, but has been basically flat for the past 18 months. This will change, when the Chinese government decides to appreciate both lending and currency rates again in 2010. We think that currency appreciation will be at least +3-6% in the coming 6-12 months.


China is not alone as most of Asia is raising interest rates.  Australia’s central bank raised borrowing costs by 0.25% on Dec. 1 to 3.75% after increases in October and November.  The Bank of Korea recently kept its benchmark rate at 2%, but it is likely to be 3% by the end of 2010. 


Similar to our view that “HE WHO SEES NO BUBBLES” (Bernanke) needs to remove his current unsustainable and unreasonable monetary policy of “extended and exceptional”, the People’s Bank of China has altered its policy verbiage from “appropriate increases” in lending to “moderately loose” monetary policy. 


Also, on December 27th, Premier Wen Jiabao said last year’s doubling in new loans had caused property prices to rise “too quickly” and that he “pledges to cool” China Property Prices. On January 7th, 2010, the Chinese sold 3-month bills at a rate of 1.37%. That was the first explicit interest rate hike in the last 5 months.


 Yesterday, the People’s Bank of China raised the proportion of deposits that banks must set aside as reserves by 50 basis points starting Jan. 18.


Since the initial debut of our CHINESE OX IN A BOX theme, there was a widely publicized article on the NY Times that fames short seller, James Chanos, who is bearish on China.  While we agree with Mr. Chanos in many respects, China has been in a BULLISH FORMATION, much like the S&P 500, up until today when the TRADE line broke.  That being said the issues with China are real.  There is an overcapacity issue with excess retail square footage space and limited increased capacity for those industries already sourcing product from the Chinese.


Howard W. Penney

Managing Director




Do You J Crew or Rue?

Do You J Crew or Rue?


The entire team is attending the ICR Exchange in rainy Dana Point, CA over the next couple of days.  Along the way we’ll be keeping you abreast of any interesting presentations, anecdotes, and data points that we pick up.  Kicking of the conference was an informal presentation by J Crew’s Mickey Drexler.  The standing room only presentation wasn’t filled with too many new insights, but one of the most respected merchants in retail did provide some interesting insights:


  • JCG will remain in a “balanced” growth mode.  A mix of offense and defense.  Questions surrounding missed sales opportunities due to tight inventory management were quickly dismissed.  There is “no hurry to grow inventory”.  Inventories planned flat for 1H10, and will continue to be planned at levels below sales growth.
  • Drexler was bullish on opportunities beyond the core brand.  Madewell.com, Madewell store growth, incremental Crewcuts catalogs, additional Men’s Stores, and bridal shop-in-shops are all part of the near to intermediate growth plan.  When asked if overall growth could be ramped up, Mickey suggested it was unlikely although possible if the right locations came along.
  • Overall bullish on e-commerce and direct business.  Drexler’s off the cuff comments on the demise of video rental stores and potential disappearance of retail bookstores (thanks to the Kindle and others) supported his commentary that “online investments are very appealing compared to bricks and mortar”.  This supports one of our core themes that retailers embracing online as a key growth driver will continue to gain profitable share. 


Following, J Crew was a unique presentation by Rue 21.  The first five minutes were centered on the company’s recent IPO, strong share price performance, growth track record, and plan to dominate retailing like we’ve never seen before (I may be exaggerating, but not by much).  Key points from Rue (that I’m not making up):


  • When asked by the company’s pre-IPO investors if they were ready to go public, the CEO responded “Why not?”.  The entire IPO process was completed in 3 months!
  • On several occasions during the presentation, the CEO mentioned that Rue is the fastest growing retailer in the U.S.  With just over 500 stores, management now believes there is an opportunity for 1,500 stores! Prior expectations were for a 1,000. 
  • It’s all about speed.  Speed to market on merchandising through exclusive use of domestic resources and US based importers.  Speed to open stores, which only takes 6 weeks from signing a lease.  Speed to double the store base which should only take another 3.5 years. 
  • Contrary to J Crew, Rue does not operate an e-commerce site.  It appears that management is entirely focused on opening stores at this point.   Oddly, this seems a bit contradictory given the core demographic for the brand is a 12-17 year old.
  • Finally, the CEO ended with “I’m proud to say our stock price is up 60% since the IPO and we’ve added $300 million to our market cap”.  Hmm…I think we know what motivates these guys.

 Do You J Crew or Rue? - 1


Eric Levine



Casey Flavin


While investors generally tend to be more optimistic at the start of a New Year, consumers don’t seem to share the same enthusiasm.  An ABC index of consumer confidence declined the most last week since February 4, 2008.  The confidence index fell to -47 in the week ending Jan. 10, down 6 points from a week earlier.  According to the ABC index, consumers don’t feel much better than they did one year ago when the index stood at -49.  


This week’s PERSONAL FINANCES measure dropped to -8 from +2 last week; the average over the past year is -9. 


Despite the market being up 67.9% from the March 9th low and all the billions the government has spent to support the economy, the measure of the consumer’s view of the STATE OF THE ECONOMY has gone from -88 a year ago to -82 last week; the average over the past year is -84.


That being said, the sharp rally in early 2010 is helping the bullish sentiment to improve.  According to Investors Intelligence the number of BULLS reached its highest level since Dec-07; the BEARS are at the lowest reading since Apr-87.


The Hedgeye Risk Management models have the S&P 500 in a Bullish Formation.  A Bullish Formation is when the immediate term TRADE (3 weeks or less) underpins the intermediate term TREND (3 months or more) and the long term TAIL (3 years or less).
Howard Penney

Managing Director



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