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More Evidence to Support our Thesis on MCD and Coffee

A Crain’s article reported today that MCD’s specialty beverage rollout is falling short of the company’s target of selling 350 specialty coffees per restaurant each week. The article states that according to MCD documents that sales in the Kansas City test market peaked at 359 coffees in one week in December and have since declined steadily to 217 a week in June. The sales results show that a majority of the specialty coffee sales are not bringing in new customers but rather are coming at the expense of regular coffee sales. Two other test markets in Bakersfield, CA and Raleigh-Durham, NC are showing similar trends.
  • I have been saying for some time now that the specialty coffee rollout would not prove to be another silver bullet for MCD’s U.S. business as I do not think MCD will be able to change consumer perception enough to steal meaningful share from Starbucks. Additionally, it will be difficult in today’s environment to convince the average MCD customer to spend $3 for a cup of coffee (as evidenced by SBUX’s recent traffic trends). This new beverage platform requires franchisee investment (costing the entire system more than $1 billion to implement nationwide) at a time when franchisees’ bottom lines are already under pressure from rising commodity costs and increased dollar menu transactions.

Hong Kong's Hot Plate Chart

The crowd bought on the news in Asia overnight, after the well anticipated Hong Kong inflation report came in at a new ytd high of +6.1% year over year. If I am right, July’s inflation data could be lower sequentially from this June report. That would continue to inspire a short term covering rally in Asia, particularly Hong Kong.

The Hang Sang Index closed at 22,532, up +3% overnight. My short term resistance level was 22,209, so this is a positive event. The next critical level is 23,742, and I will rest comfortably, dependent on the incoming data, to make a call around that pin.

KM
chart courtesy of stockcharts.com

CASUAL DINING CAPACITY PROBLEMS

According to a report by real estate research firm Reis, U.S. store closings and cutbacks turned the second quarter into the worst one for strip mall owners in 30 years. Strip malls saw average vacancies spike 0.5% to 8.2%, a level not seen since 1995. To date, we have not seen a corresponding reduction in capacity at casual dining restaurants. The reduced traffic to the malls and strip centers puts downward pressure on traffic trends at restaurants adjacent to these locations.
  • The end of the current cycle will be marked by a reduction in Casual Dining capacity.
Casual Dining traffic trends versus Vacancy rates

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VIX BREAKING DOWN - BE CAREFUL

The Volatility Index (VIX) has come in hot from our 31-32 target, correcting -22% in less than a week. A breakdown and close below the 23.99 line, gets me more confident in the holding long exposure for a continued market squeeze to test S&P-1289.

There is blood in the water. The sharks are circling the shorts. Be nimble, and be careful out there.

KM

BWS: Barron’s Told 1/2 the Story

Barron’s might be right on this stock – but for all the wrong reasons. If you want to play a short squeeze on this company coming anywhere near expectations on a lousy quarter, then be my guest. But for those of you that are actually thinking of investing in this company due to a rebound in the business – be aware that there is no reason why this company cannot go bankrupt. Seriously. Consider the following…
  • 1) 70% of sales come from Famous Footwear – a moderate footwear chain with about 1,100 stores throughout the US. There’s nothing wrong with these stores, but I’m concerned that BWS has been underinvesting in store-level capex, and is now incrementally channeling its capital towards accelerated store openings. These stores are in more expensive locations with higher rent hurdles.
  • 2) Competitive risk: there is an 87% store overlap between Payless Stores and Famous Footwear. At the same time where BWS arguably underinvested in its stores, Payless did the opposite. This puts Famous in a tough position regardless of the operating environment throughout ‘09.
  • 3) The industry risk here is tremendous. BWS is at the apex of the massive margin squeeze I expect to see beginning in 1Q09. With 97% of its product made in China (both direct and indirect), and with brand exposure that is squarely ‘caught in the middle’, this company will be a price taker.
  • 4) The wholesale portfolio accounts for about 40% of cash flow. Yes, there are some good brands like Via Spiga, and maybe even Naturalizer. But I’d argue that half of the portfolio does not even need to exist. (brands include Franco Sarto, Via Spiga, Etienne Aigner, Nickels, Private Label, Carlos, Naturalizer, Life Stride, Dr. Scholl's, plus Children's portfolio).
  • 5) BWS looks relatively healthy from a balance sheet perspective with a 21% debt to total capital ratio. But including the impact of operating leases, it is about 61% based on my math. In addition, as I outlined in our bankruptcy call last week, we also need to look at the flexibility of the operating leases – which is often the key factor in retail bankruptcies. BWS’s trend is not good. The flexibility ratio has been declining, and particularly took a leg down last year as BWS reaccelerated its growth strategy. Translation = it is getting into more expensive properties with higher lease minimums just as the industry is heading into a major margin crimp.
  • With EBIT margins at about 4%, this name might seem down and out, but the reality is that it has margins that in the same ballpark as others in the industry, and it has a materially weaker portfolio. I could make a case where margins head to zero – or worse.
  • The bottom line -- Barron’s might have this ‘Trade’ right into 2H08, but if that materializes, then this could be one heck of a short for 2009.
BWS is signing leases with more aggressive terms. This is something to watch...

Deflation Chart: Corn and Soy Have Record Weekly Declines

Agricultural commodities in general and corn and soy in particular declined sharply this week. The market had to digest both the Argentinean government’s capitulation and nearly perfect weather in the Midwest.

CBOT December corn closed at 628.5 ($6.285 per bushel) on Friday, down -20.24% from the all time high close of 788 on June 26, while November Soybeans closed at 1,448 ($14.48 per bushel) down 11.22% from the all time high close of 1631 on July 3, 2008.

CBOT September wheat closed at 804 ($8.04 per bushel) on Friday, down 36.69% from the year’s high close of 1270 on March 12 (40.42% below the all time high intra-day on Feb 27th). Remember that wheat soared in February and March on increased export tariffs imposed in the Ukraine, Russia and Argentina as well as draught in Australia.

Things can change very quickly in this market. We have been very lucky with weather for this corn crop in recent months, but the crop is less mature than it would typically be at this time of year. In recent week estimates placed only 13% of total corn crop pollinating vs. a seasonal average of 50% . If we had any additional bad weather the impact on this crop could be profound, driving total corn yield down by more than the 10% decline estimated by the USDA.

Additionally, the strikes in Argentina took many farmers off their land to work the picket lines and roadblocks, and the threat of heavy export tariffs did not encourage production during the planting cycle. Put bluntly, a lower yield caused by less ideal weather, lower stocks at harvest in Argentina resulting from the strike – or a combination of both, could return pricing pressure into these markets. Proceed with caution.

Andrew Barber
Director

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