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Eye On Leadership

One word for Merrill's new CEO, John Thain: Accountability.

Part of being a good leader is accepting that ultimate responsibility for the organization rests on your shoulders. John Thain dropped that ball yesterday when he distanced himself from his own firm in the midst of the Merrill Lynch conference call.

Goldman Sachs analyst William Tanona posed the following question:

William Tanona
“I guess in terms of you guys were obviously a big underwriter in both cash and synthetic CDOs, what did you invest the underlying cash collateral in the synthetic CDOs and what type of instruments and how are those reported on the financial statements?”

John Thain
“First of all I take exception to the you guys comment. I did not create any of these CDOs...”

Here is the rest of the quote for context

“……..I think we -it’s probably specific on the deals because whenever there’s one of the synthetics there will be a whole series of requirements as to what the collateral has to look like--in general, when you create a synthetic it will have a whole bunch of criteria about what the collateral has to look like, it had to satisfy a whole series of rating agency test, it had all kinds of diversification requirements in it and I think it’s probably not going to be easy or probably not very useful to answer your question kind of generically because my guess is that it’ll be totally dependent on each individual security. So I think that each one would be different.”

Thain is a rich man. He is also another one of these vaunted Goldman Sachs men who have been given the benefit of the doubt in managing one of America’s most important financial institutions.

Thain has an opportunity to do things differently. I sincerely hope that yesterday’s conference call is does not manifest into a “Trend” and that accountability is part of his new leadership plan.

  • Andrew Barber
    Director
Merrill's New CEO - John Thain

MCDONALDS COUPON BOOK -"CRAVE & SAVE"

In the North East, the Saturday NY Times delivery included a 9 coupon book in English and Spanish:

$3.49 20 piece McNuggets (3.99 in Manhattan)
$2 off southern style chicken extra value meal (only $1 in Manhattan)
$1 6 piece McNuggets (1.49 in Manhattan)
2 coupons -Buy 1 Big Mac or quarter pounder with cheese get one free
$2 off Angus third pounder extra value meal (only $1 in Manhattan)
2 coupons -Buy 1 bagel or McGriddles sandwich get one free
$1 off McSkillet Burrito


That is a lot of free food!

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.


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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.

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

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