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Restaurant Anthology – Part 2

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.


Restaurant Anthology – Part 1

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.
  • Food and Labor Costs

    Food and labor costs as a percent of sales have been moving up consistently for the restaurant companies as a whole in line with rising commodity costs and increasing average hourly earnings. Unfortunately, I do not see these inflationary pressures going away anytime soon. Just yesterday, YUM management stated that it underestimated the full-year impact of rising commodity costs by $45 million (represents a 6% hit to U.S. operating income growth) – posted July 17. Companies will work to offset these inflationary pressures by rising prices, but this, too, has its own set of risks as I have seen too many times concepts ruined by excessive pricing – posted July 16.

    That being said, restaurant-relevant commodity costs (corn, soybeans, wheat, cattle) have moved down rather significantly over the last two weeks. Corn futures closed down sharply, amid widespread commodity declines and pressure from outside markets, including crude oil and soybeans. U.S. wheat futures closed lower on spillover pressure from weakness in other markets and on forecasts for increasing world production. These recent moves down, however, might not be sustainable as a University of Illinois study states farmers are facing significantly higher production costs in 2009 – posted July 18.
  • Traffic versus Margins

    Restaurants are using an increased level of promotion and value messaging to drive traffic in this tough consumer environment so margins will be hit by a larger mix of low profit transactions at the same time input costs are going up.
  • YUM raised its FY08 U.S. same-store sales guidance but took down its operating profit target, which implies the company will see more, less profitable traffic as a result of its Why Pay More initiatives at Taco Bell and its pasta introduction at Pizza Hut – posted July 17.
  • Subway experienced a 14% YOY traffic increase in the February to April time period as a result of its new $5 price point. This low price point will obviously impact Subway’s margins, but more importantly, such a significant increase in traffic in today’s environment will be watched and copied by Subway’s competitors. I think the fast casual chains have the most to lose as consumers can spend $5 on lunch rather than $8-$9 – posted July 12.
  • Starbucks announced that a majority of its U.S. locations will be offering some sort of deal between now and early September. These promotions may help curb the company’s declining traffic trends, but they could also hurt the company’s already depressed U.S. operating margins – posted July 10.

JUST SAY NO (TO REVENUE SHARING)

In what promises to be a very interesting test, Bally’s Las Vegas removed all of its participation games recently. Operators, particularly Bally’s LV owner Harrah’s, have long since tried to move away from the revenue sharing model. Who wants to give up 20% or more of revenue when the payback on a slot machine is only 6 months? Participation games are by definition the best performing games so pesky consumer preference has a habit of getting in the way of cutting costs. Mandalay Bay unsuccessfully tried the same thing early this decade. That was a number of years ago so I guess it’s time for another experiment. Is this a smart move? Yes. Harrah’s operates a significant amount of slot capacity on the Strip. A drop in slot play should not move the corporate needle. I’m all for a real life cost/benefit analysis. Given that 50% of slot industry profits are generated on the gaming operations side, the slot suppliers better hope this test fails.

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EYE ON COMMODITIES – FARMER PROFITABILITY

Unfortunately, if commodity prices decline significantly, we could see another significant problem develop as most American farmers would incur huge losses if commodity prices returned to historical averages. According to a University of Illinois study, farmers are facing significantly higher production costs in 2009. As a result of the increase in input cost, higher breakeven prices are required for corn, wheat and soybeans.


  • According to the study, for corn, non-land production costs for 2009 are projected at $529 per acre, a $141 per acre increase from 2008 levels of $388 per acre and an 85% increase from the average $286 per acre cost incurred in the 2003 to 2007 time period. For soybeans, non-land production costs for 2009 are projected at $321 per acre, up by $82 over 2008 costs of $239 per acre and up 78% from the average 2003-07 level.


  • Looking at input costs, farmers are seeing the largest cost increase in fertilizer. For corn, fertilizer costs in 2009 are projected at $215 per acre, an increase of $97 per acre over the 2008 projected level of $118 per acre. For soybeans, fertilizer costs in 2009 are projected at $98 per acre, a $53 increase over the 2008 level of $45 per acre. In addition, seed costs are projected to increase significantly.


  • The study suggested that based on yield expectations of 191 bushels per acre, the 2009 breakeven price for corn is $3.82 per bushel. The soybean breakeven price is $9.65 per bushel. Needless to say, these breakeven prices are significantly higher than historical commodity prices and appear to be going higher.


  • CORN
    Corn futures closed down sharply, amid widespread commodity declines and pressure from outside markets, including crude oil and soybeans. According to the CME, “seasonally we’re at the time of year where we generally decline and weather forecasts continue to offer little support to the market.”



  • WHEAT
    U.S. wheat futures closed lower on spillover pressure from weakness in other markets and on forecasts for increasing world production. Losses in corn, soybeans and crude oil weighed on wheat. It also was seen as bearish that the analytical report Strategy Grains raised its 2008-09 European Union soft wheat production forecast to 131.7 million metric tons, up 2.7 million tons from the June projection. From a fundamental standpoint, it would appear that a big world crop is getting bigger.



Dramatic Increases in Corn and Soybean Costs in 2009 Chart from the University of Illinois report

Play Some Offense!

“Ok McGough, we’re tired of you and your team sounding all gloom and doom.” Don’t think I have not heard that from several people. But the sheer downside that remains in this space from a ‘Trend’ perspective (i.e. 3 points of margin erosion over 2-3 years) coupled with the market’s misalignment with economic reality, have supported a very bearish view. But as my colleague Keith McCullough has pointed out starting with his 10:59a.m. posting on 7/15, the ‘Trade’ is serving up a great opportunity for us to be selectively bullish, and ultimately capture volatility on both ends of the spectrum. To all you stock pickers out there – this is when you earn your keep!

In that context, here are the names I like, as well as those that pose the biggest risk.
FAVORITES
1. RL: Coming off an ‘investing mode’ period while the rest of retail was printing peaky margins. Now costs start to ebb when RL’s revenue starts to flow (Japan, handbags, dresses, Russia, leather goods, footwear to name a few initiatives). Numbers look very beatable, and cash flow trajectory is one of the best I can find in this group. Do I like valuation as much now given that so many other names have become so dang cheap? No. But the sustainability here is very impressive and numbers are low. I’ll take that, and I think the market will too.

2. TBL: The poster child for a company that invested in its business and took margins down when things got tough instead of cutting into muscle to keep margins high. I think that margins have hit bottom, and that this stock is a 2 year double.

3. FL: A massive industry shift over 4 years away from core athletic disproportionately hurt comps. Add on horrendous conversion and a boost in lower-margin Nike product as a percent of the mix, and margins went from 7% to 1%. Now performance trend is turning, and Under Armour will help on the margin. Layered over a lower cost structure and flexible lease terms, this much-hated name made it to my list of favorites.

4. LIZ: Management’s has a colossal task ahead. The good news is that cost cuts have been overinvested into the biz over the last two years. Now we’re at a point where either 1) LIZ harvests, 2) LIZ cuts, or 3) LIZ restructures massively. With cliff vesting for options in ’09 to jump start near term performance, I like how this is shaping up.

5. PSS: Not a name I’ve spoken about much recently, but one I like. Coming off a horrific year for the industry, an ill-timed acquisition, and a recent cash-draining lawsuit ruling. Not good for a zero square footage growth retailer. But all my math still tells me that this company can take up mix to the mid-teens from low-teens today. Also, with such broad distribution and with an arsenal of brands including Sperry, Keds, and Saucony, I think that PSS has the goods to be one of the winners in the new footwear landscape.

6. CRI: After being bearish on CRI’s model for a while, I pulled a 180 on CRI after the recent management change. Once earnings come down again this should shape up to be a good one.


LEAST FAVORITE
1. WRC: Yes, it’s been a crowded short. But insiders are selling, inventory/sales spread is peaking, margin compares are getting tough, cotton costs are rising (vis/vis CK Underwear), and a cleaner P&L is making it tougher for WRC to sandbag. Not good.

2. ADI: Tough sales comps in ’09 due to European Championships ’09 and Beijing Olympics come in conjunction with frontal UA assault, Nike response, and almost zero consumer interest in Reebok. Add on extremely tough product cost increases and big FX risk, and it equates to being at the top of my short list.

3. GIL: One of the most misunderstood, and overly liked, companies in retail. A well executed offshoring strategy allowed GIL to take share and dominate its core category while improving margins by 30%. Now share is tapped out, and the strategy is changing to into a less defendable business. Sales are slowing, GM is tapped out, and SG&A is way too low to support meaningful growth. I think that every line item of this P&L is trending down on a multi-year basis.

4. VFC: I actually like the company. But sales growth is decelerating, margins are getting pinched, and capital spending is headed higher. Ultimately, it is very tough to make the leap in assumptions to get to a trajectory where cash flows don’t roll. Plus, it’s tough to argue with the stats that less than 5% of the shares are held short, the ‘buy rating ratio’ is at an all time high of 67%, and numbers don’t appear to be a slam dunk.

5. SKX: We’re hitting the end of a 4-year period where a shift towards fashion and away from performance footwear combined with sourcing tailwinds and FX benefit took up margins. Now biz is turning. Inventory is showing up in bad places (Goody’s), and management is selling stock. I think margins are cut by at least a third.

6. GES: I think that the margin trajectory at GES is unsustainable. While one of the better apparel companies, I think hindsight in 12 months will show lack of brand reinvestment at the top of the cycle. FX risk here is scary.

7. DKS: UA comp cycle + =rock solid consumer + easing competitive landscape + high vendor discounts = hidden impact from aggressive lease structure over the past three years. Now every one of those items has turned – except for the aggressive lease terms. Next Q looks ok, but DKS numbers should come down again. This is one I consistently revisit on pops, including a potential rally around a sandbagged 2Q.

8. PVH: A perennial favorite for the investment community, I can’t get over the risk of a 3-400bp deceleration in menswear sales – the likely fallout from the sheer magnitude of Wall Street jobs being cut (mens dress shirts and ties represent almost 50% of cash flow).


Old School

Another morning wakeup call – “feet on the floor”, as my Dad would say. It’s time to deal with some more market volatility.

At 1260, the S&P 500 has picked up a sharp +4.9% from its intraday low of 1201 on Tuesday, and is making its bid to close up for the first week in the last seven. This morning we have to deal with what I dare say is an improving macro picture, but a deteriorating micro one. Earnings season is in full swing – Google and Microsoft are trading down -7% respectively, pre market open. It’s time for some old school trading.

Actually one of my partners from my prior days in the hedge fund business called it that this week – “old school” – and it’s appropriate. He manages billions in long/short assets now, and he is up double digits year to date. He knows how to trade, and he definitely knows how to manage risk in a down tape. If you can combine those go to market strategies with some bottoms up stock picking, you’re going to get paid this year. There are plenty of stock specific alpha bits to chew on in and out of their respective earnings releases. An old school market of stocks is emerging from a stock market.

On the Global Macro front, I simply have to call the cards as they lay. My thesis that raising rates here in the US will fix a lot of what troubles the collective wisdom of the crowd is playing out this week. Bernanke has finally admitted to the US stagflation problem, reported Asian economic growth has slowed, and the implication of near term Fed rate hikes has pushed both short and long rates up. This has crushed US bonds and stabilized the US Dollar.

This 3 day “Macro” move should be understood as a “Trade”, however. We still have a lot of hay to bail before we can open up the barns doors that we had Sally lock down, and call this a fundamental “Trend.”

For a macro “Trend” to manifest, I need to see some follow through in Bernanke’s ostensibly changed rhetoric – following through like leaders do, putting some action behind his words. I think he can raise rates by 75-100 basis points and nothing changes in terms of how Main Street America wakes up in the morning. This will help stabilize what continues to look like a pending US Dollar crisis, crush short term commodity inflation, and washout the remaining business models in this country who depend on free money leverage to earn fabricated returns.

If the US Dollar Index can close above $72.61, the CRB Commodities Index break down through the 427.96 line, and Oil close under $125/barrel, we have ourselves the right cocktail to head into our summer weekends.

For now, we’re going to head into this weekend with oil finding it’s Middle Eastern geopolitical risk bid, and the “Bear” market winning the benefit of the doubt.

Yesterday’s resistance level in the S&P 500 now becomes my support. If we break down today, and close below 1245, we could see an expeditious 30 point decline in the index.

Mr. Bernanke, the timing is perfect to draw an old school line in the sand!

Have a great weekend.
KM



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The total percentage of successful long and short trading signals since the inception of Real-Time Alerts in August of 2008.

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