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    MARKET EDGES

    Identify global risks and opportunities with essential macro intel using Hedgeye’s Market Edges.

We have recently commented on four major themes:
1. Recent trends in food and labor costs and their impact on margins
2. Use of promotions to drive traffic at the expense of margins
3. Companies levering up at the wrong time
4. All leading to a less than toxic Q2 earnings season
Although most of these themes do not sound all that encouraging, we have also outlined a couple of companies that are making the right capital allocation decisions and should see an improvement in underlying fundamental trends.
For more details regarding any of the following highlights, please refer to the relevant postings over the past two weeks, which are sorted by date on the portal.
  • Capital Efficiency
    My recent look at past restaurant bankruptcies led me to look at the casual dining sector’s current debt to EBITDA ratios and unfortunately, casual dining operators added leverage at the peak of the cycle.
  • DPZ: Looking at the overall industry, DPZ was not the only company to leverage its balance sheet at exactly the wrong time; they just took leverage to whole new level and the stock is down over 40% in the last 12 months as a result. The company’s business model generates cash, which should allow DPZ to pay down debt over time and start to reverse its current capital structure in the next 6-12 months. Additionally, overall pizza category trends have ticked up in 2Q08 so as the company’s top-line results improve going forward, investor concerns over leverage should dissipate – posted July 13.
  • Starbucks is currently taking the right steps to reverse the issues that stemmed from its excessive capital spending over the last three years. Although the company’s decision to slow U.S. growth and close underperforming stores is not yielding immediate results (as did MCD’s plan to win strategy in 2003), the current consumer environment is working against the company. SBUX is changing the things it can control, which will reward shareholders in the coming quarters– posted July 8.
  • TXRH recently announced that its board approved a $50 million increase in the company’s stock repurchase program. The company has not generated free cash flow since 2005 and its debt to EBITDA ratio has gone from 3.2% to 20.1% over the same timeframe. Because the company needs to fund its growth with incremental leverage, I do not understand the motivation for buying back shares if it will require the company to add even more leverage to its balance sheet – posted July 8.
  • Dave & Buster’s recently filed for an IPO that could raise as much as $170 million. Dave & Buster’s is another company that has a highly leveraged balance sheet, and requires significant reinvestment (which it does not have) in its existing store base to maintain the appeal of its concept. However, if the company does not deleverage its balance sheet, its growth will also be limited. This could be why the PE firms want out – posted July 15.
  • Less than Toxic 2Q Earnings Season
    Restaurant companies may see some upside to 2Q results from rebate checks, but the relief is only temporary. CPKI guided to slightly better 2Q results but did not adjust its full-year outlook. RT’s 4Q08 earnings beat consensus, but the company still expects same-store sales to be down low to mid single digits in FY09, including a 8%-9% decline in 1Q09. RRGB announced that its recent sales may trend to the low end of its previously guided assumption for the full year – posted July 9 and 10.